Do I Need Bonds?

 

Should I have bonds in My Portfolio?

 

Do I need Bonds?

Bonds are not sexy. Instead of owning a slice of a company like you do with stocks, you loan money to a company—or the government—so they can do what they need to do.

But why would an individual investor want to loan money? Why do you need bonds in your portfolio?

 

Do I Need Bonds in my Portfolio?

So, should I have bonds in my portfolio?

What a great question to ask. The Financial Independence Retire Early crowd says “VTSAX and forget it;” but is that right for everyone?

Probably not. Everyone needs bonds, at least initially. Let me tell you why.

Recency Bias

Have you ever lost 40% of your portfolio’s value? The market has been on a 10-year run, and many have not experienced the gut wrenching feeling of losing (at least on paper) a good chuck of your hard-earned money. This is recency bias, where the status quo will continue indefinitely.

Remember, the market ALWAYS goes down. Until you know how you are going to react to that fact, think about bonds. They protect you from the gut wrenching declines.

The most important part of investing (aside from just doing it), is not to sell low. When the market tanks and you panic, you lose the game of investing.

The Game of Investing

Who me? I won’t panic.

Remember, investing is a game of one. It is you against you. If history is a guide, you win if you don’t sell out at the worst time.

Investing is not a zero-sum game; everyone can win if you play by the rules. When investing, you participate in the growth of the economy in general. More people, more products, more consumption, and that growth is the reason stocks go up over time.

Paper losses aren’t real; panic selling, however, locks in the loss.

Don’t Sell Low

So, how can you not sell low?

One way: lose the password to your investment account. Seriously. If you have a 401k, for example, set it up how you want it.  Then lose your password. Don’t check it for another 1-2 years. There is nothing you want to do in there anyway.

Or cancel cable. Remember, TV’s job is to sell eyeballs advertising, and literally there is nothing important you might learn on TV about investing or the stock market.

Or stop talking to other people about hot stock tips. If a friend mentions bitcoin or blockchain (or Blockbuster), change the subject. Your friend is going to lose money.

You are going to lose your password.

Why Invest in Bonds?

Bonds are volatility dampeners. That’s it; that’s the secret. They reduce the downside in investing.

Asset Allocation and Loss

Figure 1 (Asset Allocation and Maximal Loss)

In figure 1 above, we see what effect asset allocation (bond percentage) has on maximum loss. If you are in 100% stocks, you can lose 50%. If you are in a 60/40 portfolio, you lose much less at 25%.

How does this look in the recent past?

Bond Returns in the Recent Past

 

Stock and Bond returns

Figure 2 (Stock and Bond returns from 2000-2009)

 

In Figure 2, note the returns for stocks and bonds in the beginning of this century. Stocks and bonds are said to have low correlations. When one is up, the other is down. This can help you from selling your stocks low, knowing that there is a volatility dampener in your corner.

Moreover, bonds are relatively safe investments when done correctly. There is less risk in bonds.

Risks In Bonds

Bonds are generally safe investments. Stick to US Treasuries if you want no risk, as the government insures the return of principle.

Short and intermediate term bonds decrease the risk due to increasing interest rates.

Total bond indexes are often suggested as a part of the three-fund portfolio. If you are in a high tax bracket, consider Municipal bonds in your taxable accounts.

Stay away from “high-yield” bonds, AKA Junk Bonds. Remember, the point of bonds is a dampener of volatility, so don’t go reaching for yield in your bonds (that’s what stocks are for).

Don’t Get Hung Up on Complications

Bonds are complicated. There is duration and convexity, default and interest rate risk, coupon and par…

Remember the most important part of early investing: savings rate.

Your investment return doesn’t even mater until you get a good-sized nest egg, so why take the downside risk until you are sure you can tolerate it?

Bonds in Target Date Funds

One easy way to invest is a target date fund. This type of fund has stocks and bonds in a pre-set ratio depending on your age.

Do I need bonds?

From Vanguard

Above you can see a demonstration of how target date funds go from a 3-fund portfolio and increase bonds as you get closer to retirement. Note when “young” a 10% bond allocation. Again, this is downside protection.

 

Bonds and Income

Why not talk about bonds and income. You shouldn’t expect much income these days from bonds.

As, you are investing for the future- you don’t need income. Too often, because people want income, they “reach” for yield and wind up with risky Bonds.

Don’t take risk in your “safe” investments.

Summary: Do I need Bonds?

Bonds are not sexy, but there is something to be said about the stabilizing effect they have on your portfolio.

When the market is falling apart—If they stop you from selling low—they are worth their weight in gold.

Bonds hedge against making panic decisions.

If you are new to investing and have never been through a big drop in the market, have bonds in your portfolio. During the peak of despair, if you can ignore the panic on TV and among your friends, then maybe you don’t need bonds.

If your response to a market crash instead is to buy stock when they are on sale, maybe that is the time to sell your bonds and go all in on stocks. You will be buying low!

Remember, in the beginning savings rate is all that matters. Returns on your investment don’t matter until later. Just don’t sell low!

Posted in Investments and tagged .

4 Comments

  1. Great post, I’ve clipped a couple of those tables. Investors should remember that US Treasuries (longer dated) are the best risk managers (for stocks) second only to inverse products – so many will say.

    Most people need bonds. Don’t find out when it’s too late.

    You don’t fix a ship in a hurricane.

    Dale

  2. This one has puzzled me for a long time. By this reasoning I don’t need bonds. I’ve been investing for 40 years, 100% equities for 35 of those. I have never sold a single share due to a crash. I’ve seen 40‰ drops in my portfolio and never raised an eyebrow. I’m not irrational, I knew that’s how the market historically behaves. You’d have to be kind of an idiot to sell during or after a crash. Yet now that I’m retired I only have 50% in stocks, if the only reason is peace of mind that’s wasted on me because I’m obviously immune to panic selling. In my case I’m diversified because assuming the market only follows repeating patterns and won’t do something new is just as crazy as panic selling. Being 100% in anything is too risky for me. Plus I don’t need maximum growth, or any growth at all. When you’ve won the game is when you play safe.

  3. I am retired, and I consider that a major portion of my portfolio will be legacy money. Shouldn’t I use my childrens’ target date for that portion of the portfolio?

  4. Nice post. “When the market is falling apart—If they stop you from selling low—they are worth their weight in gold.” Unfortunately, we see what happens with panic today- money leaves stocks for a “safer” investment and the 10 year treasury yield plummets.

    I maintain bonds and stick to my investor policy statement. It’s times like these when the bond cushion prevents me from selling low.

    I respect the FIRE readers out there and hopefully we can all stick to our plans and adjust as needed. Curious to see the posts from FIRE bloggers coming out in the next few weeks!

Comments are closed.