To Buy Bonds or Not to Buy Bonds; That is the Question
Reader question from Justin atRootofgood.com
“I don’t know about the bonds. Experts say put money in bonds. I’m still almost 100 percent stocks although the market is getting high enough where I’m thinking about taking some profits.
I know I should have some bonds in my portfolio, but the rates are still near record lows. Should I still invest in bonds, knowing there’s a decent chance I will lose money over the short to intermediate term?
When I was working, I had a stable enough income that I didn’t care if my portfolio swung 30 percent in a year, so I preferred the big returns of stocks. Now that I’m retired, we are supposed to have some bonds to help with volatility, but I can’t pull the trigger and buy bonds that barely pay more than inflation.
Serious question, and I keep punting from making the decision. :)”
Apart from the fact that Justin is in the enviable position of being 33 years old and retired, he’s asking a question that is a concern to many investors.
Understanding Bonds-The Backstory
Justin’s question is pertinent now because it is a certainty that when interest rates rise, bond principal values fall. That means anyone holding an individual bond or bond fund will experience a drop in value when interest rates go up. The amount of decline in the bond’s (or bond fund’s)value depends on the duration or average time to maturity. Higher duration bonds are more volatile than shorter term bonds.
On the flip side, as interest rates rise, dividends reinvested into a bond fund (or into new bond issues) will be reinvested at a lower price per share and with a higher coupon rate and higher yield.
So what is the investor, who wants a diversified investment portfolio to do?
I’ve been reading a lot about this topic, thinking about it for our family’s portfolio, and also discussing the issue with trusted colleagues in the finance world.
Given my findings, I’ll share several viewpoints and discuss the pros and cons, and then leave it up to you to decide.
Option 1: Continue with a 100% Stock Portfolio
Justin is in his early 30’s and I expect he is not living off the income from his investment portfolio.
Historically an all stock portfolio returned an average of about 9 percent per year.
If Justin has a high risk tolerance and can handle huge portfolio declines, without selling, then an all stock portfolio might lead to the greatest long term returns.
But, be aware and don’t go into an all stock portfolio blindly.
In 2008 stocks lost 35 to 45 percent. A $10,000 portfolio falls to $5,500. In 2000 to 2002 stocks lost 40 percent in value. And in 1973 to 1974, stocks lost 37% of value.
Stock prices are very volatile, much more so than those of bonds.
Jay Yoder, the esteemed portfolio manger of the Smith and Vassar College endowments, answered the question, “Should You Invest Your Entire Portfolio in Stocks?” in an Investopedia article. Along with most investment professionals, Yoder recommends investing in a diversified portfolio, which includes bonds.
Even those of us with the strongest stomachs, don’t like to see our portfolio’s drop 40 percent. And you’ll find, due to the correlation between asset classes, that adding some bonds to an all stock portfolio won’t damage returns as much as you might expect.
Personally, I don’t suggest anyone but the most daring to invest in a 100 percent stock portfolio. It is too nerve racking and there’s no guarantee that the the future performance of assets will mirror the past.
Option 2: Get a sense of your risk tolerance and buy some bonds.
Set an allocation for your portfolio, in line with your risk tolerance, and stick with that asset allocation through thick and thin. If your fairly risk tolerant and young, you might only want 20 percent of your total investment portfolio invested in bond assets.
I’m a fan of the Paul B. Farrell’s Marketwatch Lazy Portfolio’s. Take a look at the Aronson portfolio above. This is a diversified low cost index fund portfolio with allocation to bond funds (corporates and Treasury’s), and U.S. and international stock funds.
Notice over the past 10 years that the S & P 500 returned 7.81 percent. Yet, the total Aronson portfolio return was 8.00 percent. In spite of the fact that the Aronson portfolio included corporate and US Treasury bond funds it still outperformed the return of the S & P 500. This recent ten year period disproved the belief that an all stock portfolio will always yield a higher return than more diversified stock and bond holdings.
According to Gregg S. Fisher, CFA, “Bonds Still Deserve a Place in the Portfolio”.
“As we see it, the purpose of bonds in an investment portfolio is not to generate high returns (the past 30 years of strong bond returns notwithstanding) but, rather, to dampen total portfolio volatility by balancing out such riskier holdings as equities and real estate. In particular, high-quality bonds like U.S. Treasuries generally help insulate a portfolio when stocks suddenly and unexpectedly plunge (notice that I do not include in this discussion high-yield bonds, which behave more like equities than like high-grade bonds).”
Over the long haul, a diversified portfolio which includes stocks and bonds will likely minimize volatility and offer an inflation beating return.
The short term outlook is unimportant if you’re not going to need the funds until retirement. The portfolio’s short term volatility is the price you pay for the higher returns of participating in the investment markets.
Bond Investing Strategy Today
If you decide to add some bonds to your portfolio, many professionals (myself included) recommend keeping duration’s on the shorter end. Shorter duration bonds and funds are less volatile and as the short term bonds mature, their principal can be reinvested at the new lower prices with higher coupon yields.
I like John Bogle’s (founder of Vanguard Funds) approach to volatility, don’t look at the returns on your retirement portfolio until you’re getting close to retirement. And if you’re truly a long term investor, forget about the short term movements and business cycle ups and downs in your investment portfolio value.
Investors, how your you allocating your portfolio in this rising interest rate environment?
