What Portion Of Your Portfolio Should You Invest In Bonds?

By: ispeculatornew
Date posted: 03.13.2012 (5:30 am) | Write a Comment  (8 Comments)

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This is a century old debate (if not longer) but it never gets old. Why? You can easily debate from either side. Don’t underestimate the impact of this decision though. For most investors, there are two main (and often only) asset classes; stocks and bonds. Sure you can add alternative classes like commodities, REIT’s, private placements, etc. You can also break down both of those into subclasses such as domestic stocks, emerging stocks, etc. Bonds can domestic or foreign, they can be short term, long term, inflation protected, corporate, government, etc. You get the picture right?

It Is Perhaps The Most Important Decision For Your Portfolio

It’s easy to get insanely complicated but hear me out. Asset allocation is by far the biggest factor in determining the performance of a portfolio. No other decision regarding asset allocation is more important than your allocation between stocks and bonds. Why? In theory, here is the breakdown:

Equities – Higher returns, more volatility, perform best in good economic times
Bonds – Lower returns, less volatility, performs best in flat/down markets

I know, I know, some might that dividend stocks for example react in a closer to bonds, etc. But let’s stick to bonds vs equities.

Which Asset Class Is Better?

Of course, there is no right answer to that. It always makes me smile when I see charts about bonds overperforming stocks (or vice-versa) because it always depends on one critical factor; the time period. I could easily pick a period that would show you how bonds outperform stocks or the opposite as you can see here:

It simply depends on the dates that I am using. The fact is that we should all own some stocks and some bonds. The big question is how much of each.

It’s NOT A Life Threatening Decision

One thing I hate to see is so many investors being unable to make a decision. They fear getting it wrong and want to over-analyze the decision. I know it’s difficult to come up with a set allocation… What you have to remember though is that the allocations will likely change every year and perhaps even more often. The critical part is getting started and then seeing how your portfolio reacts to market movements. Then, you can adjust both proportions to better reflect what you are looking for.

Make Your Life Easier

The universal rule is quite simple. If you own 100% of your portfolio in stocks and bonds you would invest so that:

Bond proportion = your age %
Stock proportion = 100% – bond proportion

So a 30 year old would own 30% of bonds and 70% of stocks. Of course, this is a general, well known rule meant to be easy to track and understand. I still think it’s a good starting point. From that point on, you can adjust in the following way:

-Higher tolerance/capacity to take risk => diminish bond % and increase stocks %
-Lower tolerance/capacity to take risk => increase bond % and diminish stocks %

What determines your willingness and capacity to take risk? Basically, an investor that can take risk and is willing to take more risk than the average investor would:

-sleep well at night no matter how the markets reacted
-be earning more than average or own more than the average
-not need aggressive returns to reach the target retirement

So basically, depending on your profile, you would adjust slightly your proportions. I personally consider myself more willing/capable of taking risks so the %bonds in my portfolio is less than my age. Not by tons, but it is.

I would love to hear what you think about this question and what you personally have been doing?

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  1. Comment by KB — March 13, 2012 @ 7:27 am

    Forget the age thing. There is a “counter-balance” strategy whereby if one balances their “equity bucket” against your “bond bucket” you can guarantee return of all equity principle within a specific amount of time.

    Let’s take $100,000. If one has a five year window and can earn 4% within their “bond bucket” then place 82.5% in bonds, 17.5% in equities or $82,500 bonds and $17,500 equities.

    After Year 1 $82,500 104.00% $85,800
    After Year 2 $85,800 104.00% $89,232
    After Year 3 $89,232 104.00% $92,801
    After Year 4 $92,801 104.00% $96,513
    After Year 5 $96,513 104.00% $100,374

    If the ratio above is too bond heavy then one can attempt to earn more than 4% in the bond bucket and place more into the equity bucket or one can expand the time horizon where by 10 years is a 70% bond, 30% equity or 15 year which is a 56% bond, 44% equity or a 46% bond, 54% equity which is a 20 year horizon.

    This then is a strategy that is more interested in return of principle then return on principle but I can assure you it really does work. The
    key is to ensure the bond bucket can earn the 4% (or more)required to maintain the balance and the principle.

    Math and facts by John Quincy Adams; “Facts are stubborn things; and whatever may be our wishes, our inclinations, or the dictates of our passions, they cannot alter the state of facts and evidence”.

  2. Comment by IS — March 13, 2012 @ 7:17 pm

    @KB – Very interesting, I will certainly look into this. Appreciate the feedback very much!

  3. Comment by John Hunter — March 15, 2012 @ 5:59 pm

    I don’t like bonds in general. And in this market I think it is crazy to buy them. If you have to I would only buy short term bonds (under 5 years for sure – lower duration of bond portfolio is better, so you might buy some 5 year bonds while your average duration is maybe 2 years now). I would also look at treasury i-bonds (I own a small bit of these but am not adding to holdings).

    Having safer, income producing investments to balance a retirement portfolio makes sense. I would use much more dividend stocks today than bonds to do this. I would also look at MLPs. And REITs (they are not direct tradeoffs for bonds but can help balance a portfolio while avoiding the worst risks of bonds today).

    The market today makes bond investments exceptionally poor, I believe. The government’s massive intervention is greatly suppressing bond yields. That means your current return (yield) is lower than it should be. It also means when that ends (either through changed policies or a collapse of the dollar because the market loses trust in the dollar) there will be big capital loses (the longer your maturity the larger the losses. Given the meager returns on bonds today the risks make a horrible investment case. An additional risk is the return of inflation.

    I support the idea of moving to a more stable, and income producing investment portfolio as you age. The current market conditions make bond investing seem like a bad choice to me. In, or very close to retirement, I would likely have some small amount of bonds (just because the other options are far from perfect). But I would have MUCH less than suggested and would instead seek alternative ways to balance the portfolio. And further away from retirement I may well have nothing in bonds (I have less than 2% myself (but have more in cash – which pay even lower yields than bonds today but avoid the risks, which is a very good tradeoff in my opinion).

    As I said I never have liked bonds much. But the market today, makes following the conventional wisdom much worse than it normally is. Normally I would have less in bonds more in other investments but following the common wisdom is an ok strategy in my opinion. Today I think it is crazy to follow the historical investment portfolio bond advice.

  4. […] What Portion Of Your Portfolio Should You Invest In Bonds? […]

  5. Comment by Stephen — March 16, 2012 @ 8:31 pm

    Apparently I have high risk tolerance without me knowing about it since I have only 16% in bonds. I’ve been adding more bonds in my retirement account though and looks like I should continue to do so in coming years. I don’t want to get caught with too little bonds and too much stocks next time the cow dung hits the fan.

  6. Comment by IS — March 17, 2012 @ 4:59 am

    @John – I’d be the last guy to argue with you… I do think that this is a almost certainly a bad time to buy bonds, a lot of downside but very little upside.

    That being said, while I am underweight in bonds, I do still think they add value and since in that specific account (my retirement one) I try to avoid timing my investments, I am still buying some bonds, even now. I do understand your point of view though.

    @Stephen – Higher than average or than the “standard” weight of bonds:)

  7. Comment by Stephen — March 19, 2012 @ 10:41 am

    I was talking about bond standard. According to bond rule I should have more than 50% in bonds.

  8. Comment by Intelligent Speculator — March 19, 2012 @ 7:11 pm

    @Stephen – Got you, thanks:)

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