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The Role of Bonds in a Portfolio
We are led to believe there are certain things we need in our financial portfolio. Common wisdom implies that we should seek bonds to level out the volatility of our investments. But, is there any truth to this?
A brief review from our last post:
Stocks are traded on an equity exchange where individuals or organizations seek to purchase shares of organizations. Examples of stock exchange markets in the United States are the NYSE and the NASDAQ.
Bonds are exchanged either over the counter or as part of a fund (ETF or index). In purchasing a bond, or a similar index or ETF fund, you are lending money to either a corporation or a government entity at a fixed or floating interest rate as determined at purchase. Practically speaking, by purchasing a bond you are lending money to one of these agencies similar to the way the bank lends money to a borrower. Essentially, you are the creditor in this relationship.
Investment wisdom suggests that individual investors should have a percentage of their investments in both stocks and bonds. One of the oldest rules of thumb is to have a percentage of your overall portfolio in bonds equal to your present age. Then, over time, adjust your allocation into greater proportions of bonds as you increase in age as a primary means of decreasing your overall volatility and increasing your fixed income. Using this example, if you just turned 30 years old, it is time to rebalance to owning 30% of your total portfolio value in bonds. When you turn 40, adjust to own 40% in bonds. Etc.
Personally, I prefer a different approach. I plan to delay my investment into bonds until I am much closer to actually needing the money in my investment accounts. This would typically happen around "retirement age", which is a concept that is increasingly being revised due to the FIRE movement (Financial Independence, Retire Early).
So what would make me delay my investment into bonds? Let's take a closer look.
The Risks and Rewards of Bonds
The universal argument for owning bonds in your investment portfolio is to decrease overall volatility. As many will learn, equities (stocks or index funds/ETFs consisting of stocks) contain a great deal of volatility.
Vanguard has already done the heavy lifting on this one. Take a look at the results they came up with.
100% Bond Portfolio from 1926–2018*
In the 93 year period between 1926 and 2018, stocks nearly doubled the return of bonds (10.1% vs. 5.3%). However, bonds had a positive return 79 of those years while stocks had a positive return in only 67 of those years. The 12 year difference in positive returns in favor of bonds are why many folks choose to hold them.
Further, the worst year for bonds was an 8.1% loss (1969) whereas the worst year for stocks was a 43.1% loss (1931). Imagine your portfolio showing a -8.1% return in a given year, versus a -43.1% drop in value. If you have trouble imagining such a significant drop and would be likely to sell during such a period, perhaps owning a greater percentage of bonds in your portfolio is an idea worth considering.
Keep in mind however, the trade off for stocks is that typically the greater risk is usually for a greater potential reward. Past results are not an indicator of future performance however!
Do Bonds Offer Diversification?
When considering bonds for a portfolio, the typical investor seeks diversification into different asset classes. Ideally, these asset classes should have a correlation as close to 0 as possible. For those folks into rebalancing, a negative correlation is even better.
When a correlation of 0 exists, the two items you are comparing are believed to have no relationship with one another. The closer an asset class gets to -1, the more the two asset classes move in opposite directions with one another. It is important to note that we will rarely, if ever, find asset classes that consistently move in the opposite direction of stocks.
It has been long said that stocks and bonds have an inverse relationship with one another. Conventional wisdom says that when stock prices are up, bond prices are down. Conversely, when stocks drop, bond prices tend to increase because investors are typically seeking bonds for stability and decreased volatility during market drops.
However, this is far from a universal rule. In fact, stocks and bonds have recently been moving together. As of 2020, many investment grade and corporate bonds show a positive correlation with stocks. Further, many sources such as Morningstar have demonstrated a correlation greater than 0.5 (the closer to 1 the more related two asset classes are).
The authors over at Seeking Alpha have a great article showing how the diversification into different asset classes has been diluted since many asset classes move together (correlation closer to 1). Check out this article and take a look at the last chart on the page. The darker the shade of gray, the more closely related two asset classes are.
"Food" for Thought
Perhaps you read all of this and discover bonds are a safer alternative than stocks and you choose an aggressive bond allocation (somewhat paradoxical). Maybe you review the notes above and decided the complete opposite, bonds are for the faint of heart and stocks are the way to go. Either way, I would consider reviewing this article, and any notes you have taken, annually to see if you still feel the same way.
I will leave you with somewhat of a reaching analogy. Stocks and bonds are somewhat related to Aesop's classic fable of The Tortoise and The Hare. It's not a perfect analogy because stocks (hare) typically do beat bonds (tortoise), but it outlines the importance of where you are presently in the race of life. As mentioned above, the older the investor the greater the number of tortoises in their portfolio. Why? Slow and steady is believed to win the race. However, consider that you may want to be the hare in the beginning of the race, and switch over to the tortoise down the road to get the best of both worlds. Regardless, consult with your financial professional prior to making any lasting decisions.
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