EducationInvesting

Buy stocks or bonds? 3 numbers to help decide

Stocks or bonds

It is widely repeated in the investment community that the biggest difference in whether you earn high or low rates of return as a long-term investor is not your choice of an individual stock or bond, but how much you allocated overall to stocks vs bonds. The more you put in stocks, the more likely your investment is to multiply 10x or even 100x over several decades. The problem is that many human beings (myself included) have trouble always keeping this in mind when seeing stocks swing +/- 20% over a period of months, and market timers who try to “buy low and sell high” rarely do as well as those who simply stick to a simple plan of buying regularly and not sweating the ups and downs. Just like non-doctors may take a temperature to judge if someone is sick, I thought it might be useful to highlight if not one number, at least three numbers you can use whether to buy stocks or bonds with your next monthly investment:

  1. The number of years until you need the money back
  2. The yield on your favorite bond, and
  3. The P/E ratio on your favorite stock index

When do you need the money?

Although I prefer to spend my time looking at interest rates, P/E ratios, and dozens of other financial metrics, the #1 number to decide whether you should buy stocks or bonds, whether with your next $1,000 or $1,000,000, is when you’ll need that money back. If you know you’ll need to withdraw that money to buy a property six months from now, there is no reason to take the risk of stocks going down and leaving you with less than planned. In shorter periods of time (which in markets often means less than several years), stocks can move up or down by 10%, 20% or more, often in opposite directions to the actual profitability of their underlying companies. As a rule, I say money that you need to spend in less than 2 years, and in many cases up to the next 5-7 years, should not be in stocks. I will sometimes put REITs or preferred shares in a middle ground here, but those next 2-7 years are what I call your “liquidity runway”, and you don’t want that runway moving up and down on you. Beyond that, inflation and the longer term return premium on stocks become more significant factors, so I also say MOST money you do not plan to spend in the next 7 years should be in stocks not bonds.

Highest interest rates for “safe money”

A second important number to look at is what interest rate you can earn on that “safe money” you expect to withdraw within your “runway” period. It continues to amaze me how much money is kept in low interest bank deposits beyond the minimums required to keep the account open and write that month’s cheques. For US dollars (and Hong Kong dollars, minding the peg risk), you should at the very least be earning the yield on US treasuries on your cash, which as of this writing is around 2%. If you have Euros, Yen, or Swiss Francs, short-term rates on those currencies are currently zero or negative, which might shorten your cash runway and encourage you to invest more in stocks that at least have a dividend yield of 2-4%.

Even within a currency, interest rates can be higher or lower for shorter or longer term bonds, and you should generally earn more investing in bonds issued by companies than by top-rated governments. When longer-term rates go lower than shorter-term rates, that is often a sign of an upcoming recession.

Estimating your expected rate of return investing in stocks

I am often asked “what is the return” a client should expect on the portion of their account I invest in stocks. The difficulty in answering in this is that stocks may have averaged a nominal (before subtracting inflation) rate of return of around 10%/year, that was in the past, and even as an average, it can mean gaining +30% one year and losing -20% another year. It often takes at least a decade to meaningfully approach an “average” rate of return, and even then, I find forward looking numbers more useful than past performance numbers.

Although simple, the “Price/Earnings Ratio” or “P/E”, is probably the closest thing to a “temperature” you can read on a stock or stock market index. As explained in my earlier post on the only two ways to make money in stocks, you make money either by waiting for a stocks earnings to come back to you in the form of a dividend or higher base value, or by finding someone who will pay you a higher multiple of the same earnings on the stock. When you buy a stock with a P/E of 10, it only takes 10 years of equal earnings (assuming zero growth) to make your money back, and 10 P/E stocks may have an easier time rising to a P/E of 14 than a 30 P/E stock would have rising to a P/E of 42. Of course, one main reason the 30 P/E stock is trading at a higher multiple may be because the market expects its earnings to grow more than those of the 10 P/E stock, but markets tend to be overly optimistic about future growth, and value has outperformed growth over longer periods.

I wish financial TV channels would report the P/E ratios, rather than simply the price levels, of indexes, but provided you can get past the far greater choice of stock benchmarks than interest rates, you can add the P/E ratios of some of these funds to your dashboard:

The last two are a focus on the US, specifically following the below chart published by the CFA Institute last year, showing that the premium of growth stocks over value stocks in the US is reaching levels not seen since the early 2000s. On top of that of course, it also shows how much more expensive the US is vs the rest of the world.

Russell 1000 Growth vs Value PE

Although P/E and one interest rate is far from the complete picture, these three numbers are simple and ready enough to make the most important part your decision to keep investing this month, rather than letting analysis paralysis trip you up on the simple decision of whether to buy stocks or bonds. As the Nike slogan says “Just do it”.

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