Young Investors: Buy Bonds Now, Stocks Later

by: John Gerard Lewis

Young people are almost always advised to throw almost all of their investible cash into stocks. That's worked well over most periods of time, as the long-term average annual return on stocks has historically been in the 10% range. The esteemed Jack Bogle, founder of the Vanguard Funds, has quantified this maxim with a simple formula: invest your age in fixed income, and put the rest in stocks.

The idea, of course, is that stocks generally return more than bonds, but with their attendant higher risk they are proportionally less suitable as an investor ages.

Fair enough. But you only get one shot to be young, and if stocks suffer a prolonged period of stagnation when you're, say, 30 years old and finally have some money to invest, you may not be able to enjoy having nearly all of your money growing at the robust rate historically provided by the stock market. If the market returns just 0% - 5% annually during an investor's 30s and 40s, an investor will miss the best opportunity to substantially grow the greatest percentage of his portfolio.

Which brings us to today's 30-somethings.

The most recent 10-year annualized return for the Standard & Poor's 500 index has been just over 6%, significantly lagging the historical average. And over the past five years, the Standard & Poor's 500 has, in fact, provided a negative return. No one should absolutely rely on any given forecast for stocks a decade out, because no one even knows what the stock market is going to do even one year hence.

(In January, pick up the Barron's Roundtable issue, and see how accurate the experts were in their year-end market predictions. Even they are fully aware that throwing darts might yield better results.)

But more than a few well-regarded observers think the long-term future is bleak. Economists in a recent Bloomberg survey estimated that mean real gross domestic product will grow by slightly more than 2% annually through 2014. And Bill Gross, the highly-regarded founder of Pimco, thinks GDP will grow by a paltry 1.5% for at least the next 10 years.

That would not bode well for stocks or bonds. "If real GDP grows at 1.5%, then a diversified portfolio of stocks and bonds would probably grow at 1.5% as well," Gross says.

A young investor thus faces a conundrum. All this money to invest, and I'm only going to get 1.5%?

I have the utmost respect for Bogle's allocation rule, and I follow it. But I would advise today's 30-year-olds to initially ignore it. There is ample reason to believe that Bill Gross is right. In fact, I would tell a young investor to avoid stocks altogether and invest in a carefully selected portfolio of corporate bonds. Not bond funds, but individual corporate bonds.

Here's the reasoning. Because there is a significant chance that investment returns could be virtually nil, or even negative, over the next decade, a next-best alternative for a young investor, who needs to take advantage of his youth, should be sought. Ideally, this alternative would be characterized by a reasonable chance of capital preservation while returning a rate closer to the historical return on stocks. It's not likely going to be found in the debt of sovereigns, but it might well be found in the investment-grade debt of corporations.

It is possible for someone who has accumulated beginning capital of $100,000-$150,000 to invest in just ten corporate bonds and obtain a yield to maturity of over 7%. Granted, just 10 holdings aren't optimal for diversification, but it's adequate for someone in his 30s. Risk-taking is for the young, and we're trading the risk of little or even negative return for some modest initial diversification risk. Besides, as more investible cash is accumulated, more bonds can be bought.

A sample portfolio of 16- to 28-year bonds of the following companies have an average annual yield of 7.48% (as of July 18, 2012): Provident Companies, American General, AXA, Telefonica Europe, Safeway, Genworth Financial, May Department Stores, Fairfax Financial Holdings, Telecom Italia Capital and Validus Holdings. All of these are rated at least BBB-, which means they are investment-grade bonds.

Now, the average maturity of the portfolio is 25 years, but we're not going to worry about prices being driven down by rising interest rates, because these bonds are to be held to maturity. That's why we're not investing in bond funds - their holdings have varying maturity dates.)

Assuming no default or bonds being called by the issuer, the investor is going to get his principal back, plus 7.48%. It's a bit less than the historical equity return, but we're pursuing this as an alternative to what could be a poor stock market for years to come.

Why accept the possibility of 1.5%, when 7% is available? If you're young, lock-in that rate with the money you have today. Sure, it's a long holding period, but, in my opinion, it's a wise move, given today's desultory stock market. If prospects for the stock market grow brighter, invest any newly available money in stocks. That's when you can begin to make amends with Mr. Bogle.

Disclosure: I am long GNW.

Additional disclosure: The author is long bonds of Genworth Financial, but not the common shares. This commentary doesn't constitute individualized investment advice. The opinions offered herein aren't personalized recommendations to buy, sell or hold securities.