Financial markets are in a period of major volatility with wild swings occurring for stock, bond, and commodity prices across the globe. The U.S. dollar is devaluing compared to foreign currencies at an aggressive clip with the looming threat of tariffs potentially disrupting global supply chains. Chaos seems to be the norm, especially with the rapidly changing policies coming from the Trump administration.
Heightened price movements and stock drawdowns can make you question your investment strategy. Should I be invested in stocks? Or should I flee for safe assets like bonds? You will hear varying opinions on this decision. To better understand proper portfolio allocation, let's look at historical data to illustrate the difference between stock and bond returns.
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Stocks and market drawdowns
Stocks are the best performing asset class over the long term. Over the last 100 years, U.S. stocks have produced an annual return of around 10%. Adjusted for inflation, this is slightly lower but still a strong real return for anyone who has bought and held stocks for decades at a time.
How powerful is this compound interest? Someone who deposits $10,000 into an investment account each year with a 10% average annual return will end up with just under $13 million in 50 years. That is the power of the stock market and major indexes like the S&P 500(SNPINDEX: ^GSPC).
A major risk of investing in stocks -- and this is one investors should not ignore -- is the market drawdown. There have been 27 stock market drawdowns of more than 20% for the S&P 500 since 1928, which is the threshold for triggering a bear market. Sometimes, the drawdowns are especially severe and can take years for the index to recover to fresh all-time highs.
This is especially impactful if you need to take distributions from your portfolio within a short time window. A down payment for a home, starting a small business, or simply covering expenses in retirement could all be reasons to take a distribution from your stock portfolio. If the market is down over 30%, this would be suboptimal timing for making withdrawals from your portfolio.
What can investors take away from this? If you need to take cash out from your portfolio within the next 10 years, that money may not be entirely safe in the stock market. Investing in stocks is best viewed as a long-term endeavor, and it should only be done with cash you know can be invested for many years.
Resilient and stable bond performance (with a catch)
So what should you do with cash needed in the near term? A mix of bonds can solve this issue and help your savings maintain their purchasing power, at least in most historical situations.
Bonds have weaker long-term returns than stocks. U.S. Treasury bonds have generated around 5% annual returns for investors in the last 100 years, or around half that level when you include inflation. However, bonds experience less severe drawdowns of around 10% to 20% in a bond bear market. This can help protect your assets when saving for upcoming expenses such as a home down payment or monthly retirement spending.
One problem with bond returns can be inflation. In periods of elevated inflation like the few decades after World War II in the U.S., bond returns can remain below the level of inflation for a long time, which erodes your purchasing power. To counteract this, an investor may want to purchase Treasury Inflation-Protected Securities, otherwise known as TIPS. As the name suggests, these are Treasuries that have an inflation hedge built into the instrument.
It is not a question of stocks or bonds but your personal situation
So historically, stocks have outperformed bonds but with more severe drawdowns, and bonds have lower but steadier returns. Understanding this trade-off can help with personal financial planning.
Are you under 40 with no major upcoming expenses to save for in the next 10 years? Then, you may be comfortable with a portfolio dedicated entirely to stocks. But if you're starting a family and saving for a home but still decades away from retirement, a portfolio of 60% stocks and 40% bonds -- known as the 60/40 portfolio -- may make sense for you. Over the age of 75 and spending down savings in retirement? A portfolio made up of mostly bonds may be ideal.
Investors shouldn't decide whether to own stocks or bonds based on what asset class they believe will exceed expectations in the next year (trying to predict this is an act of folly, too). Notice how I have not discussed once what stocks or bonds may do in 2025. Instead, focus on your personal financial situation to determine what allocation of stocks and bonds makes the most sense for you over the long term.
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Brett Schafer has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
