Why Is This Important?

The spreadsheet shows wonderful long-term increases over very long periods of time.  This is, by itself, not amazing.  You'll find many stock scenarios that look far better, turning the theoretical 1947 investor into a multimillionaire.  So, why isn't America awash in multimillionaires?  There are several reasons, but the main one is that the widely published figures are bogus.

I think that stock yields are vastly overstated over time.  First, they gloss over management fees, which reduce final results hugely.  Almost all actively managed funds consistently under-perform their benchmarks for this reason alone.  Second is portfolio churn.  "Bad" investments are constantly being sold in favor of "good" new ones.  Each time, a layer of transaction costs (buy-sell spreads, broker fees) erodes results.  Third, taxes are ignored, even though many investors must pay them.  Fourth, the weak, lame, crooked and incompetent are undercounted, as they usually go bankrupt and disappear from the averages.  This also applies to fund families.  Typically, an investment giant will launch a flock of new funds, and eventually merge the failures into the winners.  The former's crummy results are no longer visible in the family's "stellar" long-term results.  Factor all this in, and a long term return on a stock portfolio will easily fall to 7% annually, or less.

Now look at the Bodacious Bond Machine again.  How does its 7.65% compounded return fare relative to the flaws discuss in the previous paragraph?

Fees: there are none.  You run the portfolio; you don't collect a fee from yourself.

Portfolio churn: there is very little.  Bonds are bought and held until maturity.  Of course, bonds will, after 30 years, be retired and force reinvestment of the funds returned to you.  I wouldn't call that churn, though.

Taxes: they are are typically higher on interest than on capital gains or dividends. This is a negative for a bond portfolio, but taxes can be deferred or eliminated through a tax-deferred or post-tax (Roth IRA) plan.

Fallout:  this is a real issue for bonds too.  Occasionally, a company defaults on its bonds, causing severe losses.  However, the plan's focus on investment-grade bonds reduces this risk considerably.  For example, since 1981, the average default rate for BBB- bonds (the lowest investment grade) has been .28% (see http://en.wikipedia.org/wiki/Bond_credit_rating).  That drops to .16% for BBB+ bonds.  In both cases, there are many years when the average rate is 0%, as defaults tend to be cyclical, associated with recessions.

Note, that this default rate would not necessarily be fully realized.  Your could, for example, sell a given issue once it is downgraded to junk.  For most companies, the road to default is gradual.  Companies on the brink (Albertson's, Sears, Lucent, Sprint, Clear Channel, MBIA) have been declining for many years.  Selling them as they turn into junk would have caused losses, but a limited portion of the investment.  Even if the bond defaulted entirely, there might still be a return of capital once the company is reorganized or liquidated.  One clear implication of default rates is that your bond portfolio should be diversified, both over time and company type.  The first is accomplished by regular yearly purchases, achieving an automatic ladder of new bonds and ones nearing maturity.  The second is your responsibility.  Pick carefully, and widely.

Summary:
Can you see why this is so important?  Do you now get why the case for bonds is so compelling?  If a realistic expectation for a long-term stock investment is really only in the 7-8% realm, and I believe it is, then you'd be nuts to pursue that return with stocks when it is freely available with bonds.  Instead of sweating bullets every time the market swoons, you can relax in the sure knowledge that your bonds will recover.  Paper losses are irrelevant!  A stock that drops 50% in value overnight might come back from the dead, but the bond will make the return journey for certain (barring default, of course).

So, again, why are there so few multimillionaires, either from stock or bond investing?  The major reason is psychology.  It's rare for anyone to really follow a plan.  Psychology swings investors back and forth like a pendulum.  They panic when the market has punished them, and swing to exuberance when it's soared.  Since you CAN'T predict tops or bottoms, the only way to take advantage of them is to be steady.  Over time, a regular investment will capture peaks (typically when bond prices are low), and keep from going overboard when prices are high (and yields low).

So, can YOU follow a plan?  Probably not; most people can't.  I do think, though, that my plan is far easier to follow than one based on stocks.  The main reason is cash.  You can see it arrive, on schedule, twice a year, every year.  You can then take that cash, reinvest it, and watch even more come in, on schedule, twice a year, every year.  This is very comforting.  It might be enough to keep you on track, year in, year out.

My next blog will start with specific ways to implement the PLAN.  Eventually, I'll also talk about a forbidden topic: bond timing.