As you probably know if you’ve been following this blog for very long, I tend to recommend rather high equity allocations for those of us who still have multiple decades to go until retirement.

My own retirement portfolio is 90% in stock index funds, and as I’ve discussed before, I don’t see anything wrong with being 100% in equities if you’re still quite young and have a particularly high tolerance for volatility.

The fear

You’ll often hear that being so heavily invested in equities is dangerous. People say things like, “What if stocks go to zero? You could lose all your money if you aren’t diversified.”

That’s true. And it’s an understandable fear. After all, we’ve seen several high-profile occasions on which (individual) stocks went to zero over the last decade.

However, the way I see it, there are two major problems with worrying about a similar thing happening to an internationally-diversified portfolio of stock index funds.

First, it’s extremely unlikely that all (or even most) of the businesses in the world economy will become valueless.

Second, if that were to happen, bonds would offer you absolutely no protection.

Bonds won’t save you.

For the entire world stock market to go to zero (or for that matter, to earn any substantial negative return) over, say, a 30 or 40-year period, the businesses that make up our global economy would have had to collectively become unprofitable. This, of course, would have several ramifications:

• You would lose your job.
• So would every other person living in a country with a developed economy.
• The world economy as we know it would have completely collapsed. And we would each be reliant on our abilities to produce physical goods to sustain ourselves.

Note that in such a scenario, having had your IRA and 401k go to zero would be the least of your concerns. Of course, there are things you can do to prepare yourself for such a situation. For example:

1. Learn to grow your own food, and
2. Buy a gun.

As you may have guessed, I’ve done neither of the above–although I suppose my wife is currently looking into what edible plants can be grown indoors. The point, though, is that “own bonds” is not on the list.

In an environment in which business are no longer making any profits, corporate bonds would be just as worthless as common stocks. And government bonds would almost certainly be as well. (If nobody is making any money, how would the government have any tax revenue?)

So is there any reason to own bonds?

In short: Yes. There certainly are some valid reasons to include bonds in your portfolio. (More on this tomorrow.) [Update: See follow-up post here.] However, protecting yourself from a doomsday/economic collapse scenario is not one of those reasons.

The state of Oregon is suing Oppenheimer Funds for understating the risk it took while managing a bond fund in the state’s college savings plan. From the Wall Street Journal:

Oregon charges that Oppenheimer Core Bond fund, which was in the state’s 529-plan options billed as “conservative,” became significantly more risky starting in late 2007 or early 2008. The fund lost 36% of its value in 2008, but its benchmark index, the Barclays Capital Aggregate Bond Index, rose 5.2%.

“The Core Bond Fund was no longer a plain bond fund,” the complaint says. “It had become a hedge-fund like investment fund that took extreme risks.”

When you invest in an actively-managed fund, there is a chance that the manager will make some excellent decisions (or get lucky), and thereby substantially outperform the relevant index/benchmark.

On the other hand, there is also a chance that he’ll get horribly unlucky or make a series of bonehead mistakes, thereby causing the fund to severely underperform.

In other words, active management makes your returns less predictable. It adds an additional level of risk.

The way I see it, taking on additional risk only makes sense if you’re being compensated with an increase in expected return. Unfortunately, as we know, choosing active funds over passive funds does not increase your expected return.

[Quick note: I say "expected return" rather than simply "return" because the very nature of taking on risk means that returns are not possible to predict precisely. Example: Stocks have a greater expected return than bonds, but there's no telling ahead of time whether stock returns will be greater or less than bond returns in any particular period.]

Many investors gain comfort from knowing that a professional is managing their money. Odd as it may sound, I gain comfort from knowing that nobody is managing mine.*

*Yeah, OK. I guess I’m managing it in the sense of choosing an asset allocation, selecting specific index funds, and so on. But you get the idea.