Why Not 100% Stocks?

The Common Question

A question frequently debated among investors, particularly younger ones with decades until retirement: Why would anyone allocate money to bonds when stocks have historically delivered higher returns over long periods? If you won't touch your portfolio for 30 or 40 years and can stomach short-term volatility, shouldn't you maximize expected returns by investing 100% in stocks?

It's a logical question with surface appeal. Stocks have indeed outperformed bonds over most long timeframes. For investors who won't panic-sell during downturns, the argument for all-stock portfolios seems compelling. Yet most investment professionals recommend including at least 15-20% bonds even in the most aggressive portfolios. Understanding why requires moving beyond simple historical return comparisons.

The Battery Concept

Perhaps the most insightful framework for understanding bonds' role comes from viewing them as stored investment capability - essentially a battery for your portfolio. This perspective fundamentally changes how we think about asset allocation.

Rebalancing During Downturns

When stock markets decline significantly, bonds serve as a stable reserve of capital. While your stocks have fallen in value, your bonds typically maintain steady prices or may even appreciate if interest rates decline. This creates a powerful opportunity: you can sell bonds (discharge your battery) and buy stocks at depressed prices.

The timing proves crucial. Market crashes often coincide with economic recessions. During these periods:

• Job losses increase, reducing or eliminating your ability to contribute new money
• Bonuses and raises disappear precisely when stock prices are most attractive
• Emergency expenses may arise, forcing you to conserve rather than invest cash
• Credit becomes tighter, making borrowed funds unavailable or expensive

Having a bond allocation means you have purchasing power when you most need it. You're not dependent on earning new income to capitalize on market opportunities. The bonds you accumulated when times were good enable you to buy stocks when they're on sale.

Recharging During Bull Markets

The battery analogy works in both directions. When stock markets surge, the opposite dynamics emerge. Your career typically benefits from economic expansion - you receive raises, bonuses, promotions. You have more income available to invest, but now stocks are expensive relative to historical norms.

A balanced portfolio forces disciplined behavior through mechanical rebalancing. As stocks rise and exceed your target allocation, you sell some and buy bonds (recharge your battery). This happens automatically if you maintain consistent allocation targets. You're effectively selling high - taking profits when stocks are expensive - and building reserves for the next downturn.

Conversely, an all-stock investor contributes new money throughout the bull market, continuously buying at elevated prices. When the inevitable correction arrives, they have no dry powder. Their only option is selling stocks at losses or hoping they still have earned income to invest.

The Uncertainty Principle

Even over very long periods, stocks' outperformance over bonds isn't guaranteed. This surprises many investors conditioned by charts showing stocks beating bonds from 1926 to present. The issue lies in how we interpret historical data.

The Sample Size Problem

Modern stock market data typically begins in 1926 - less than 100 years ago. For a 40-year investment horizon, that provides only two truly independent periods (1926-1965 and 1966-2005). Comparing 1927-1966 to 1926-1965 doesn't create independent samples - they share 39 years of identical data.

Imagine judging a sports team based on only two games ever played, under different rules, with different players and referees. Would you confidently bet everything on the outcome of the third game? Stock markets operate similarly - conditions change, economic structures evolve, and past relationships may not persist.

Your Single Timeline

Statistical probabilities matter less than individual outcomes when you have only one investment lifetime. If stocks happen to underperform bonds during your specific 40-year accumulation period, it provides no comfort that they outperformed in previous periods or will outperform in future ones you won't live to see.

Unlike casinos that can rely on probabilities across millions of bets, you get one bet spanning your working life. A single adverse outcome affects your entire retirement. You cannot diversify across multiple lifetimes or restart if markets don't cooperate during your specific accumulation years.

Probability vs. Certainty

Stocks are more likely to outperform bonds over long periods. This probabilistic advantage justifies meaningful stock allocations - perhaps 60%, 70%, or even 80% depending on risk tolerance. But "more likely" doesn't mean "certain."

The appropriate question isn't whether stocks usually beat bonds over 40 years (they do), but whether you can afford the consequences if your particular 40 years prove exceptional. An all-stock portfolio requires accepting that small but real possibility of underperformance when it matters most - during your accumulation years.

Practical Allocation Guidance

Risk-Appropriate Positioning

A 60/40 stocks-to-bonds allocation represents reasonable balance for many investors. This provides substantial equity exposure to capture long-term growth while maintaining adequate reserves for rebalancing opportunities. Those with higher risk tolerance can increase stock allocation to 70% or 80%.

Even aggressive investors should consider retaining at least 15-20% in bonds. This modest allocation provides meaningful rebalancing capability without substantially reducing expected returns. The cost of insurance against adverse scenarios remains manageable while benefits during market stress can be significant.

Age and Time Horizon

Young investors with 30-40 year horizons can reasonably maintain higher stock allocations than those approaching retirement. However, "young" doesn't justify eliminating bonds entirely. The rebalancing benefits and risk management principles apply regardless of age.

As retirement approaches, gradually increasing bond allocations makes sense. Your ability to recover from adverse markets diminishes with shorter time horizons. The battery concept remains valuable, but you need larger reserves as flexibility decreases.

Personal Circumstances

Individual situations influence optimal allocation:

• Job stability: Secure employment or diverse income sources may justify higher stock exposure
• Emergency reserves: Adequate cash savings reduce need for bond allocation
• Pension or Social Security: Guaranteed retirement income acts like bond holdings
• Risk capacity: Wealth level relative to lifestyle needs affects appropriate risk-taking
• Emotional temperament: Ability to stick with strategy during crashes matters more than theoretical tolerance

Implementation Strategies

Disciplined Rebalancing

The battery concept only works if you actually rebalance. Set specific thresholds for action - perhaps when allocations drift 5% or 10% from targets. Calendar-based rebalancing (annually or semi-annually) also works, though threshold-based approaches better capitalize on major market movements.

Rebalancing forces uncomfortable but profitable behavior. When stocks crash and fear dominates headlines, rebalancing compels you to buy. When euphoria reigns and everyone feels bullish, it forces taking profits. This systematic approach removes emotion from decisions.

Tax Efficiency

Implement rebalancing tax-efficiently:

• Use new contributions to rebalance before selling appreciated assets
• Execute rebalancing sales in tax-advantaged accounts when possible
• Harvest tax losses in taxable accounts during rebalancing
• Consider asset location - bonds in tax-deferred accounts, stocks in taxable accounts for preferential capital gains treatment

Bond Selection

For the battery function, high-quality bonds work best. Government bonds or investment-grade corporate bonds provide the stability needed. High-yield bonds behave more like stocks, reducing diversification benefits and undermining the rebalancing strategy.

Duration matters less for young investors since you're not depending on bond income. Intermediate-term bonds balance interest rate risk with yield, though longer durations may provide better stock diversification during crises when interest rates typically fall.

Common Counterarguments

"I Can Just Add More Cash During Downturns"

This assumes income remains available during recessions. History shows that job losses, reduced bonuses, and business slowdowns often coincide with stock market crashes. Relying on future income that may not materialize creates vulnerability precisely when opportunity emerges.

"Bonds Are Guaranteed to Lose to Inflation"

High-quality bonds may underperform inflation over very long periods, but they serve purposes beyond absolute returns. Their role in enabling rebalancing and reducing portfolio volatility justifies inclusion despite modest real returns. Additionally, inflation-protected securities (TIPS) address inflation concerns directly.

"I Have Decades Until Retirement"

Long time horizons increase stocks' probability of outperformance but don't eliminate uncertainty. More importantly, the rebalancing advantage applies regardless of time until retirement. Missing the opportunity to buy stocks at 2009 prices because you held no bonds hurt young investors just as much as those near retirement.

Conclusion

The question "why not 100% stocks?" deserves thoughtful answers beyond simple return comparisons. Bonds provide strategic value through enabling rebalancing, reducing single-timeline risk, and creating flexibility to capitalize on market dislocations.

Young investors can certainly maintain aggressive allocations - 70% or 80% stocks makes sense for many. But eliminating bonds entirely sacrifices valuable optionality for modest expected return gains. The cost of maintaining 15-20% in bonds remains small while benefits during market extremes can be substantial.

Investment success over 30-40 years depends not just on choosing good assets but on behavioral discipline. A balanced portfolio with systematic rebalancing provides structure that promotes profitable actions during emotionally charged periods. It's not exciting, but it works reliably across varying market conditions - a valuable attribute over multi-decade investment horizons.