Top fund manager Bill Nygren says investors who are dumping stocks in favor of bonds in an effort to lower the risk in their portfolio are using erroneous logic.
In his second-quarter letter to Oakmark shareholders, Nygren talks about how investors allow “prejudices” to lead them to make bad investment decisions. One that is in effect now, he thinks, involves the fact that investors are prejudiced to think that bonds are safer than stocks. “In our finance courses, we all learned that bonds are less risky than stocks,” he writes. “Their returns, if held to maturity, are certain, whereas equity returns remain uncertain regardless of the holding period. But … we have relatively little history of bond yields being so close to zero. And when valuations are at extremes, as we believe bonds are today, historical price volatility might not shed much light on future risk.”
Nygren lays out some scenarios and data showing how bond investors could lose significant portions of their principal if bond yields rise to even average levels over the next decade, while stocks could prosper with even moderate earnings growth and reasonable price/earnings multiples. “We believe valuation levels today trump the historical analysis of stock and bond volatility,” he says. “We believe that investors who are trying to reduce risk by selling stocks and buying bonds are probably increasing their risk of losing money. Investors have developed a prejudice about riskiness of asset classes that ignores valuation levels. Prices of stocks and bonds will need to change if investors are forced to reevaluate that prejudice.”
Nygren also discusses why he thinks investors focusing on high-yielding dividend stocks are making a similar mistake, and why he thinks companies that use profits to buy back shares may be more attractive than those that pay big dividends.