Episode 98: Should A 30-something Physician Have Bonds In Their Investment Portfolio?

Last week, we talked about the importance of comprehending a couple key principles of investing to enable you to see it through if, and when, the stock market storm does hit. Today is going to be another investment focused episode. This is going to be an elementary asset allocation discussion surrounding bonds.

Justin (00:49):
Buy-Ins for partner physicians, really excited for that. Also really looking forward to tackling the implications of the no surprises act, which was covered under the COVID relief bill. Back in December, that’s going to take place in January of 2022. There’s going to be big implications here for physicians, especially in anesthesiology, and to some extent in pain management for the no surprises act. So we’re going to tackle that in an upcoming episode, but for today stocks and bonds, I want to talk about, do we actually need both in our portfolio? And obviously this is a loaded question. So let me start off by saying that the implications for this discussion are big. They will have real-world outcomes. And if you invest in the stock market heavily, you will lose money over certain periods of time, perhaps a lot of money for long periods of time. It’s very important that you don’t listen to this podcast and then run out and change your stock allocation, or sell all your bonds or invest all your cash.

Justin (01:48):
That would be exactly the wrong thing to do. Today’s discussion is not a recommendation to buy or sell any security or to change your asset allocation in a vacuum in any way whatsoever. It is something that should only be done in conjunction with a trusted financial advisor who knows your situation and is well-credentialed to assist you to answer these questions based on your personal circumstances. That’s very important because we’re going to talk about taking more risk. And whenever that conversation comes up, you need to know that risk is risky. You will lose more money than if you take less risk in these types of circumstances when it comes to stock market investing. So just internalize that. And really, I really mean it today when I read this disclaimer, but with that out of the way, let’s talk about common uses for fixed income. Also known as bonds in a diversified portfolio and asset allocation also known as the pie chart that makes up all of your money is most simply broken down into two colors on this pie chart, stocks and bonds.

Justin (02:51):
This is going to be an elementary asset allocation discussion. So stick with me, stocks are the risky part. They drive growth. They are shares of ownership in businesses that earn profits. You’re entitled to a share of those profits as a tiny, tiny fractional part owner, as profits grow, share prices grow, and the owners make more money for bonds. Bond ones are less risky and they’re more stable than stocks. And here’s the reason it has to do with what’s called capital structure. Meaning when it comes to company, there’s a lot of ways that a company can raise money. One is through an IPO, an initial public offering. Another is through issuance of debt or issuing bonds. A bond is what’s known as a secured obligation. So when you hold a bond, for example, Walmart issues, a bond, they pay you a 5% coupon. So every year, if you buy a $10,000 bond, you get $500 from Walmart.

Justin (03:51):
If Walmart stops paying that $500 a year, they are in default. And because you’re a bond holder, what that means is you actually have a right to some of their stuff it’s secured. So if Walmart goes into bankruptcy, they’re going to presumably depending on how it goes down, they’re going to auction off all their assets and divide whatever’s leftover and the bond holders get paid back first. Now, imagine if you’re a stockholder versus a bond holder in this situation, if you’re a stockholder in Walmart declares, bankruptcy, your stock goes to zero and you’re not getting anything. If you’re a bond holder, you’re probably not going to get your whole $10,000 back, but you’re probably going to get some portion of that back because you’re in the front of the line compared to the stockholders who were in the back of the line, when things are going well for Walmart, you’d rather be a stockholder because the stocks, they could go up five, 10, 15, 20% a year or more.

Justin (04:46):
If things are going really great, the bonds, if you’re holding a bond from Walmart, you’re only gonna get 5%. That’s what they’ve promised is 5% per year. Even if their business doubles and they’re shooting the lights out, doing an amazing 5% is what you get. And it’s a very different value proposition if you’re a bond holder rather than a stockholder. So it’s important to understand what is the purpose of a bond or of a bunch of bonds or a bond fund if you’re holding bonds in your portfolio, because there is this risk trade-off, there’s four purposes that I could readily think of. And I want to run through them briefly. The first is providing a reliable income. There are some times in which you, you like that $500 on every 10,000 that helps. And that’s an important part of your financial picture to have that coming in each month, each quarter, each year.

Justin (05:40):
The second reason have bonds is to keep you psychologically sane because it’s a less risky component of a diversified portfolio. If you were all stocks, you would be crazy rollercoaster up and down. And if you integrate some measure of bonds, it will mitigate some of that risk and allow you to hopefully be less stressed. The third purpose is related to the second and it has to do with smoothing returns, whenever stocks tank the math of your portfolio is going to be more favorable. You’re not going to sell off as much as the stock market at large. If you have some component of bonds in your portfolio, because bonds, again, they’re boring. They’re going to keep on paying you that percentage. And they will fluctuate somewhat in price, but they’re designed the purpose of them is to be designed to be less correlated, to not do the same thing as stocks at the same time.

Justin (06:35):
And so they’re helpful in that way. And the fourth reason, fourth purpose you might have bonds in your portfolio is to rebalance when the time comes, whenever that big stock market crash happens, and stocks go way, way, way down, like in March of 2000 and of 2020 COVID happens, stock markets in a free fall. That’s a perfect time to rebalance. I did this for many of my clients. You go through your portfolio and say, if I was 90% stocks, 10% bonds. And now my portfolio was, so stocks did so badly. I’m now 70, 30, 70% stocks, 30% bonds, even though I didn’t place any trades, it’s just the values. Fluctuated stocks went way down and stock and bonds remain stable. What you can do in that instance is you sell some bonds of that 30% you sell it back down to 10%. And then of that 20% that you just freed up in cash because you sold the bonds. You’re now buying stocks. And you’re doing that at a much lower price, obviously, because again, we just said they’re in free fall because COVID in this instance. So these are four potential purposes, reliable income, psychological sanity returned, smoothing and rebalancing. So what

Justin (07:49):
I want to do is evaluate the

Justin (07:51):
Purposes of bonds for, I’m going to say like a 30 to 45 year old physician, many of the listeners of this show, how does it make sense to think about bonds in your portfolio?

Justin (08:03):
Do you value,

Justin (08:05):
Or do you care about any of these four things I just listed or should perhaps we jettison the entire idea of bonds for a period of time. There’s a lot of factors in, in a person’s life that they need to answer and address in order to really understand a personalized answer to this question. But I want to give you a few things to think about first. I want to specifically address this question to a high income physician who has a moderate to high savings rate, somewhere between 15 and 25% of your gross income, your savings. So if you make $400,000 a year, you’re saving a hundred thousand dollars. This is all gross, not thinking about taxes. So if this is you, if you make 400 K and if you were saving a hundred K let’s think about these four reasons. If you’re a 33 year old anesthesiologist, number one, reliable income, am I looking for reliable income in my portfolio at this point?

Justin (09:04):
I mean, you’ve got a 401k. You’ve probably got a Roth IRA, and maybe you’ve got a taxable account. If your spouse, if you’re married, your spouse perhaps has the same. Do I value a 5% reliable coupon payment from Walmart or their peers? No. I mean, probably not like it doesn’t matter. My investment horizon is very, very long. I’m continuing to plow money into these investment accounts and whether or not there’s a coupon payment hitting every quarter. Isn’t something that worries me or concerns me. I’m more interested in growing this money that I’m not going to access for three decades. The second consideration, how does this help? How does this bond or bond allocation help with psychological sanity? Now this is real. And this is perhaps the most important, the best argument in favor of a meaningful bond allocation is it will give you the assurance that you have a more conservative portfolio than if you were a hundred percent risk on hundred percent stocks. And

Justin (10:07):
What that can do is give you the

Justin (10:11):
Emotional fortitude to see a plan through, because you’re way better off being 70, 30, 70% stocks, 30% bonds. Even though I would say, if you’re a 32 year old, perhaps that’s a little conservative, but you’re better off doing that and sticking to it than being a hundred percent stocks, 0% bonds, because your friends tell you, or some guy on a podcast told you it was a good idea. And then you lose your nerve or you freak out, or you start getting anxious, losing sleep, and maybe commit the unforgivable sin of selling all of your equity holdings at a time of market distress. Whenever their prices are way down. And this happens all the time, it happens every market cycle. We hear stories of people who have done this. So knowing yourself is really critical to understanding how much, what percentage of bonds is right for me.

Justin (11:00):
So one way to look at a proxy of like, what, what is perhaps common for someone my age or conventional wisdom. One way to answer that is to look at a target year fund. You know, if your proposed retirement date could be in 2050, if this is 2021, you’re going to work for 30 years, there’s these target year funds. You probably have them in your 401k or your four Oh three B plan, the Vanguard target year 2050 fund. I’m actually going to pull that up right now. And what happens is these funds are meant to be a one-stop shop, fully diversified with both stocks and bonds, to be able to make you not have to worry about having to rebalance or do anything with it. And the 2050 fund is 90% stocks, 10% bonds. So there is some measure of bonds and none of these target date have zero, as far as I’m aware.

Justin (11:56):
It depends on the fund family. Maybe there are some out there that do, but the point is when it’s a long time until you retire, there’s less of a need for bonds. And this component though, is one. You need to address this psychological stress that you’re going to be under watching fluctuations in your portfolio. Now, if you think Justin, I’ve only got a hundred K in the port in the stock market, if it goes from a hundred to 70 to 50, like I don’t care, cause I’m still plowing money in, then that’s great. And you know something about yourself, but if you’ve got 750 K or a million or a million and a half or 2 million, and you think, Oh my gosh, if my 2 million went to 1.1 in the span of a month, as it might have between February and March of last year, if you were a hundred percent equity, then I would have had a breakdown that’s important to know, and we need to take that into account.

Justin (12:46):
The third application, smoothing returns. To what extent as an early career physician, are we concerned with smoothing returns? Again, this is linked. This is the math part of number two, psychological sanity. Are we concerned with return smoothing? I mean, to some extent, yeah, it can be helpful. You only know, in retrospect, if the math was actually beneficial, were you better off being 90 10 or a hundred zero or 80 20? Depends on what stocks do for the next 30 years. But that is a consideration that is a benefit that exists for for people who have a meaningful bond allocation. Is that a compelling reason for a 34 year old doctor to have 20% bonds? I’m not sure. And I want to talk about why, and it’s also linked to this fourth reason, rebalancing, like whenever stocks go way down, one of the benefits of having a bond allocation is to sell the bonds and buy the stocks.

Justin (13:48):
Is that a compelling reason for a 34 year old to have a 20% 30% allocation to bonds in this instance, I don’t want to directly answer the question, but I do want to make an observation. If you are, if you have a 25% savings rate, you’re saving almost $10,000 a month into the stock market. So January $10,000, February $10,000, March $10,000. And you can imagine over time, the stock market is moving all over the place. It’s going up, up, down, up, down, and as it fluctuates, the each purchase each $10,000 purchase across your 401k and your Roth IRA and your taxable account, all this money that’s going in every month is buying at whatever the market price is right now. So effectively what this does is it, it it’s like a rebalance where you’re buying in stocks after they have quote unquote corrected or after they’ve gone down, but you’re just buying them literally all the time.

Justin (14:48):
So that if we had a six month or a 12 month recession, you would be buying in January buying, buying, buying in March, buying in June, buying, buying, buying in September, October, November. So that as stocks are going down, down, down, there are more and more on sale. You’re getting more and more value and you’re buying, buying, buying in that circumstance. You’re getting immense value from this savings rate, immense value from this systematized purchase plan. And you don’t need any bonds in order to accomplish that. Even if you had, you know, half a million bucks

Justin (15:24):
Or, or more like this is a circumstance

Justin (15:30):
In which a very high savings great and

Justin (15:36):
Serves the same purpose

Justin (15:37):
In this manner as what you would want from your bond portfolio. Now, obviously whenever your portfolio gets so big, that it’s several times your annual income the impact is more muted instead of buying, you know, 10% of your total portfolio every month being added. If you start with a hundred K and you’re adding $10,000 a month, that’s 10% of your total value. If you’ve got $2 million and you’re adding 10% a month, that’s 0.5%. So you need to think about it differently if you have a seven figure portfolio, but for early career physicians, if you keep plowing money in that is going to be a much bigger determinant of asset growth, much bigger than the stock to bond mix. And frankly, you could argue that it kind of renders the mix conversation, not irrelevant, but certainly much less important. Another element of this is remember conversation last week we had about time horizons and this goes to this psychological benefit, this like wanting to not be anxious, not be nervous if we know, as we heard last week, that there’s literally never been a 20 year period where returns were negative after 20 years.

Justin (16:51):
If we know that we don’t need to access funds for 30 years, cause I’m 33 years old and I want to work until I’m in my sixties in some capacity, maybe not full-time, but keep on working because I love what I do. And I’m 32 right now from a math standpoint, you could conceivably go 10 years of investing in just stocks without ever having to build up a bond allocation and have a reasonable, you know, historical basis to believe that every dollar that you invest for the next 10 years will be worth more 30 years from now than if you had diluted it with some measure of stocks. Now, again, historical returns don’t tell us the future. They give us context, but they don’t provide guarantees, but it can help frame the way that we think about this. I had a conversation last week with a client.

Justin (17:41):
They came in with all stocks. This was a new client. And they, it was a seven figure portfolio, a percent equities. I asked them how they fared during coronavirus. They said, they knew that it was bad. They did not open their March statement and that because they knew they knew what was happening and you know, what they managed and they got by. And it just so happened that the COVID sell off ended that quickly. And they check their June 30 statement and they were, they were back up to where they were in January. They were lucky. It may be that if they were in a protracted downturn they may not be able to hold the line unless they again had this context and knew what they were doing. If, if you’re saving six figures per year and buying $10,000 of stocks per month, it really does mitigate some of that risk.

Justin (18:35):
This is not complicated. Having a high savings rate, plowing a bunch of money into a growth oriented asset class is not complicated, but it’s not easy to do for year after year after year. And to not be, not have to deal with a psychological stress in a way that is negative. Understanding this rationale, understanding the timeframe over what you’re investing, understanding the purpose of stock investment. And by the way, when I say stocks, I’m not talking about picking your favorite 10 stocks. I’m not talking about buying splitting evenly between Tesla, Apple, Google, and Facebook. I’m talking about a broadly diversified portfolio. Whenever I help my clients invest their equity portfolio. I’ve got somewhere between 12 and 13,000 different stocks spread across a handful of mutual funds, fully diversified us international developed emerging markets all industries and sectors and all of that. So diversified when I’m talking about stocks, it’s important that when you’re building a stock portfolio, you do the same.

Justin (19:39):
One last thing that I want to close with is I know this is a little bit technical. We’re talking about a pie chart. We’re talking about ratios and, you know, optimal times to buy and sell. This is not fundamentally a mathematical optimization problem. Dr. Dan Crosby, one of the very early guests on this show back all the way back, I think in episode eight had this idea of what he calls anxiety, injusted anxiety, adjusted returns, meaning it is not worth it to max out on your stock exposure to the, to the exclusion of bonds and ride the rollercoaster. If it’s causing you to lose sleep, if it’s causing you to be anxious, if it’s making you fight with your spouse about money, if you’re stressed and it’s impacting you, you don’t need to be mathematically optimal. A mathematically optimal approach would say, well, if the expected return, you know, is 15% in this very concentrated asset class, that I should put all my money in that and stay in that for as long as possible.

Justin (20:38):
And that gives me the highest [inaudible] return. That is sort of true in a strict math sense, but in the real world, that’s terrible. It’s a terrible way. First of all, your outcome may be very poor. And second of all, psychologically for my anxiety, anxiety adjusted good basis, that is not a good way to live. You’re going to just be stressed rather. You want to understand that there’s balance mathematical optimization would also say don’t order lattes and never get guacamole on your burrito because we’re mathematically optimizing, but in the real world, we don’t live like that. So if you want or need bonds in your portfolio, some measure of bonds, whether it’s 10% or 20%, or even as a 35 year old, if you’re like, I want to be 60, 40, I literally want to have the same portfolio as my, you know, my father is 65 and I’m 35 and we have the same portfolio because that works for me then great.

Justin (21:37):
That can work. And the nice thing is if you save a hundred thousand dollars a year and he’d do that for 30 years, whether you’re 60, 40, or 90 10, it’s probably gonna work out. And if you stick to the plan and implement it in a disciplined fashion over time, it’s probably going to work out. So mathematical optimization, obviously we want to be mathematically aware, but that is not the final governing principle. You’ve got to have the real world filtered to make sure that this works for you in the trenches. So that’s, that’s pretty cool content. I hope that’s helpful. The real point today is to take a look at your portfolio, take a look at what’s in your 401k and your Oh three B and your Roth IRAs, and make sure that you’re not leaving returns on the table by being too conservative, too early.

Justin (22:25):
If you’re in your thirties and you have a big chunk in bonds, I’m just asking you this. Why are you doing that? And make sure you know why, if you don’t know why, and you want to have a conversation, drop me a line, or there’s some other, you know, great resources. If you go to APM success.com/resources, check out the page there. I’ve got some favorite blog articles, a couple of books, and some things where you can construct a portfolio thoughtfully to be able to be a good fit, to be able to deliver you the returns that hopefully are going to carry you to financial independence, carry you to financial independence sooner rather than later. So that’s all I got for today. Thanks for tuning in. Look forward to speaking with you next week.