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Investing and the Worst-Case Scenario

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.

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Comments

  1. Another zinger Mr. M. This is a rational argument and one that is often difficult to hear when investors are in the throws of fear-tantrums.

    Good one ….

  2. Although I’m not currently in the market, I can definitely related to this theory. I still think it would be hard for my conservative side to stomach, but I’m interested to see how my perspective changes over the next few years getting out of debt!

    Good read!

  3. I think it should go
    1. Own a gun.
    2. Grow your own food

    Gun is more important… if all rules fall apart =D

    I do have a question; so does this mean bonds and stocks are correlated?

  4. Now there’s a fun question SJ.

    No, it doesn’t mean they’re correlated in real life. (Just ran a calculation in excel. The correlation coefficient of year-by-year stock returns to year-by-year bond returns for the period 1928-2008 was 0.0186. If you look at after-inflation returns, it jumps up to 0.1076–higher, but still not very high.)

    What I’m suggesting is that in an extreme economic catastrophe scenario, they would become correlated (as they’d both be moving rapidly toward zero value).

  5. Your portfolio will never again suffer large losses if you simply learn to hedge (reduce the risk of owning) your investments.

    Conservative option strategies are ignored by financial pros, the press, an stockbrokers. But they are easy to understand.

  6. Niklas Smith says:

    Re. Mark Wolfinger: The problem with hedging is that it costs money. I think Mike’s point is that any fluctuations short of global meltdown will be ironed out over a period of decades. If you have only a few years left to retirement then by all means hedge or switch to inflation-indexed bonds to protect your capital. But if you’re in your twenties or thirties I suspect hedging can only lose you money over the long term.

  7. Thanks for doing the analysis! Are they also un-correlated in time? Does debt vs. ownership receive benefits at different notions in time?

    Also, wondering where you might have gotten the data… cheers!

  8. emailing you the spreadsheet now…

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