Tuesday, June 14, 2016

The reality of buying bonds

I was watching John Oliver this evening as I was waiting for my dinner to cook and as I was eating. He was talking about financial advising (which is an application of my education in economics) and as usual most of his show was absolutely right. He was right about fiduciaries, how small fees in the beginning of a retirement plan adds up to millions of dollars over a career, and how index funds are usually the best way to go for safety which is growth.

The short video at the end was right about these, but there was one thing it was absolutely wrong on, and that is the claim of buying bonds to ward off risk when you retire. While it sounds really good to know exactly how much you will have next year and it sounds secure, it is easily debunked by asking this question, would you rather lose 40% of $10,000,000 or keep 100% of $2,000,00 this year? Knowing that in the long term index funds always beat bonds, and that the S&P 500 reclaimed all of its growth in the beginning of 2013 from the 2008 crash and is now roughly 48% above its peak value before 2008 and that it is showing no signs of stopping (given our positive bond yield curve which predicts no recession in the near future) there is absolutely no reason not to invest in this index fund.

This comes down to opportunity cost ultimately, money that you don't earn because of a lower interest rate is at the end of the day the same thing as money you lost. It doesn't matter if you had and lost or just never made money, and the reality is that there is no 10 year period where a bond portfolio has beat the S&P 500 or NASDAQ. It just doesn't happen. And there is no reason to expect the future will be any different. Assuming that we don't have a massive unprecedented change in the stock market I calculated how this would look for people who start investing at 25 and then compared the stock plan versus stocks and bonds. The first one is a simple index fund getting 8% interest a year (which is what you should expect on average in the long run) and then you are withdrawing three times your cost of living (which since I assume you will own your house by that point is fairly low) from your porfolio. This person retires with a net worth of over $740,000 and will get more interest than they need to spend, making retirement an option. This is without an employer matching plan which if someone has they then they obviously will have a stable retirement which is what I prove in the second sheet with a 50% employer matching program where the person retires with a portfolio worth over a million dollars.

The third and fourth sheet however use what the Daily Show recommended, and the difference in the amount of interest you earn in the long run by moving your retirement fund into bonds is enough to put you on the verge of bankruptcy if you maintain a middle class lifestyle.

Another note with my work is that people should put as much money as possible into their account, and only putting $2000 away the first year is not really that much compared to what people should be putting away. 10-20% of your income is usually affordable for long-term investment and you should always put away as much as possible. This is the bare minimum amount in order to make a point. Plus, there are other ways to finance housing which can also make a huge difference in your ability to save.

At the end of the day, the mathematical reality is that moving your money into bonds once you already have enough money to support yourself is a very bad strategy. Most people do not know how to predict the economy, only professional economists have the tools to do that, and it takes more than a 5 minute Youtube video to learn to do it safely. You have to understand how the economy is structured, where all of the general principles come from, and even then most trained economists don't use them appropriately. The only time proven strategy which is used by millionaires which doesn't put your future at risk is to have a straight index fund in capital, be it domestic or a diversified international portfolio in a buy and hold strategy. Randomly picking stocks beats most financial advisors because they are trying to beat the market without understanding the underlying reality of how the economy works and they end up doing everything after the market has adjusted.

But if there is one iron law of investing it is the principle of opportunity cost which is why you should never buy a bond for a long-term investment.

My proof on why this strategy doesn't work:

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