Bonds have been getting a bad rap recently. Investors have been reducing their bond allocation for years as the stock market rises to new highs. Some investors, especially younger ones, are even talking about eliminating their bond allocation altogether and holding 100% stocks.
People have their reasons for avoiding bonds. They are worried about the current low interest rates and the news that the Federal Reserve will raise rates in the future. They are worried that bonds do not go up as much as stocks, and investors are having a fear of missing out on potential stock gains. Investors are also losing their fear of the stock market, forgetting that the stock market can drop over 50%, as it did during the financial crisis.
The Case for Bonds
However, there are many reasons to include some bonds in your portfolio, even in today’s market:
Stock and bond returns are relatively uncorrelated, providing diversification benefits
One of the benefits of holding both stocks and bonds in a portfolio is their relatively uncorrelated returns. When stocks overperform, bonds tend to underperform and vice versa. For example, during the financial crisis in 2008, U.S. stocks returned -37.0%, while U.S. bonds actually rose by 5.1%. During the Great Recession, investors fled stocks for the safety of U.S. bonds (especially U.S. Treasuries). Holding bonds during these turbulent times softened the heavy losses that nearly all investors experienced. On the other hand, when the stock market is rapidly rising, bonds tend to underperform.
The exact correlation between stocks and bonds is not constant; Fidelity shows a nice graph of the correlation between stocks and bonds over time. The correlation between stocks and bonds over a 5-year period stays between 0.5 and -0.5 most of the time (two assets that are perfectly correlated would have a correlation of 1).
Bonds reduce the risk of your portfolio
By allocating a certain percentage of your portfolio to bonds, you reduce the volatility of your portfolio. While you reduce the expected return of your portfolio by adding bonds, you also sleep better at night, especially when the fear in the market is at its peak.
My experience is that most people cannot handle a 50% drop in their portfolio. Bonds help cut the maximum loss of your portfolio. As Jim Dahle rhetorically asked in his defense of bonds, if you want 100% stocks in your portfolio, why not 110% stocks? How about 150% stocks? You can actually do this by using leverage, either directly by buying stocks on margin, or indirectly by not paying off low-interest loans such as a mortgage, student loans, or auto loans.
Don’t worry about the very low interest rates
Current interest rates are only one piece of the puzzle in determining bonds returns. Remember that yield does not equal return. Companies can default, and your return will typically be less than the stated yield.
When most people think of interest rates, Treasury bond yields or the federal funds rate usually are the first things to come to mind. Treasuries are assumed to be risk-free, but corporate bonds are not. If corporations default at a less-frequent rate than expected, then you get to keep more of the higher interest rate that the corporation promised to pay. This would boost your returns. Interest rates could rise and you could still make money if the economy is good and few companies go into bankruptcy.
How Much Bonds Should Be In My Portfolio?
So if you’ve decided to add bonds to your portfolio, how much of your portfolio should you allocate to bonds? Of course, this is a personal decision based on your own risk tolerance, but let’s look at some rules of thumb that financial advisors have given investors over the years.
Age in bonds rule
One of the classic asset allocation rules of thumb was to invest your age in bonds. So a 30-year-old new attending physician would have 30% of their portfolio in bonds and 70% in stocks, while a 65-year-old retiree would hold 65% in bonds and 35% in stocks. This works well, but tends to be more conservative than what most investors prefer today.
Especially at older ages, I think that the age in bonds rule is too conservative. It’s too conservative for retirees because they need the boost of higher stock returns to maintain the value of their portfolio as they deplete it over time. The 4% safe withdrawal rate popularized by Trinity University researchers required retirees to hold at least a 50% stocks / 50% bonds portfolio. If they held a 25% stock portfolio, the probability of outliving their money declined to an unacceptable level. It is important for even retirees to hold a significant portion of their portfolio in stocks.
Age – 10 or Age – 20 Rule
People have tweaked the age in bonds rule by introducing modifications to the rule, such as bonds = age – 10 or bonds = age – 20. Essentially, this allows younger investors to hold a minimal amount of bonds in their portfolio.
Bond Allocation of Target Date Funds By Age
Vanguard has many target-date funds, which are excellent alternatives to creating your own index fund portfolios. If you want to leave the asset allocation to the people at Vanguard, you can just determine your expected retirement age, and purchase the appropriate target-date fund. It is instructive to see what Vanguard believes to be the ideal asset allocation for people of different age groups.
The table below shows the bond allocation of Vanguard’s various target-date funds. The age listed assumes that you retire at age 65.
|Age||Target Date Fund||Bond Allocation|
Here is Vanguard’s bond allocation of their target-date funds by age in chart form:
Note that there is no age where Vanguard recommends a 100% stock portfolio. They always have at least 10% bonds up to age 40.
There is no “right” bond allocation. How much bonds you include in your portfolio is a personal decision that is based primarily on your tolerance for risk. Of course, never tweak your asset allocation based on how the market is doing. It seems obvious, but you see more and more people asking whether a 100% stock portfolio is appropriate. You only see that in a strong bull market. Pick a bond allocation, and slowly increase it as you get older and get closer to retirement.
My bond allocation is 10% of my portfolio, which will slowly increase as I get older. Keeping the Trinity University study in mind, I never plan to have more than 50% of my portfolio in bonds.
What do you think? What is your bond allocation? How do you plan to increase it over time? How much bonds do you plan to hold in retirement?