https://docs.google.com/spreadsheet/pub?key=0AmMlf3bsV3rFdFQ3eDBDeXRCTEU4a2FtOHlpUFMtM0E&output=html
The spreadsheet demonstrates the results of following a bond investing plan. I believe it yields consistent results over time, and avoids most of the huge losses that periodically plague the world of stocks. I think it is fairly simple, yet produces eye-popping results.
The spreadsheet has four inputs: a starting year, investment amount, lump sum indicator (is this a one-time investment, or a regular investment adjusted yearly for inflation?), and a tax rate. All the scenarios depicted here assume a regular investment amount, with no allowance for taxes. I'll discuss a lump-sum scenario in a later post.
You might be amazed to learn that the plan is simplicity itself: start with a base investment amount, and use it to buy BAA 30-year bonds every year. Each year, increase that base amount by the prior year's inflation rate, to ensure that the same purchasing amount is invested each year. Also, reinvest the prior year's interest. Ignore the ups and downs of the stock market, and ignore periodic panics about inflation, war and pestilence. Repeat every year for MANY years (a minimum of 20, preferably 30 or more). You'll love the results!
Don't take this too literally. "BAA 30-year bond" is a guideline. You might buy bonds with a lower or higher rating (as long as they're investment-grade). You might buy bonds with shorter or longer maturities, depending on what looks favorable when you're ready to buy. Over time, you want a mix of maturities and industries, but buying every year will tend to smooth things out
The spreadsheet demonstrates results for every initial year from 1947 to the present. For each such year, 10, 20, 30 and max (whatever the end year is) results are shown. The benchmark is inflation. To determine how well a time series has done, an inflation "toll" is subtracted from the portfolio's end value. The difference is an after-inflation return. What is striking about the results is that very few years show a negative return relative to inflation. The worst is the earliest start year, 1947. It starts out with nine straight years in which inflation is higher than the bond returns. This is largely due to the fact that inflation 1947 was over 14%, and over 8% in 1948, while BAA yields were slightly over 3%. This anomaly was due to the end of rationing in World War II. However, this same series shows a final portfolio figure of nearly $4.75 million, even after adjusting for inflation! All this from a total investment of $302,000 over 65 years (1000 inflation adjusted dollars every year).
While 1947 shows huge returns, so do more recent time series. 1980 was a terrific time to start (a little over 30 years). A total of $65,000 becomes $463,000 by 2011. But 1990 wasn't bad either. It turns $30,000 into $100,000. And 2000? $14,000 becomes $27,000. In fact, EVERY time series beats inflation by the 10-year mark! By 20 years, every time series outperforms inflation by a large amount.
How could this be? The magic lies in two factors: the power of compounded interest (an amazing thing) and the fact that the BAA yield was higher than inflation in all but 5 of the 65 years covered by the spreadsheet. That excess yield compounds to produce stunning results. Now, is this potential growth unique to bonds? Not at all. Most stock-return charts will show similar, or even better results. The difference is that bonds are far less volatile, far more predictable, and ultimately, far safer than stocks. Given the choice, in my opinion, you should always opt for the safer investment that still meets your investment needs. That is, hands down, the bond option.
Here, again, are a few cautions. The spreadsheet is a back-tested artifact. It takes advantage of hind-sight. The assumptions it makes are not guaranteed to work going forward. Most of its spectacular returns are due to that huge spike in interest rates in the late 1970's and early 1980's. Critically, it presumes that you don't have to pay taxes along the way (or that you pay them from outside the portfolio). Most of the excess return comes from the regular reinvestment of income. Remove some of that for taxes, and the results drop drastically.
The huge advantage of a plan oriented to bonds is that losses can be pretty much ignored. Repeat: your "losses" don't matter! Those terrible drops of 1979-81 were on paper only. They had NO effect on income, which continued unbroken, and increased very nicely in subsequent years due to the giant yields locked in along the way. You don't need to worry because there is a "correct", predictable end price for a bond. It is par. What happens in the meantime is irrelevant, as the price will end, upon maturity, at 100 cents on the dollar. The only thing that can hurt you along the way is a default (very very bad), or a margin call (so don't overuse margin).
The advantage of a "system" is that you have far fewer tough choices to make. Each year, you're going to buy BAA bonds, 30 years out. Yes, you have to decide which bonds, and when to buy during the year. I'll have some more suggestions about these lesser issues in a later blog.
So take a look at the spreadsheet. Then, you can kick the tires and mock the assumptions.
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