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The “Right Mix” of Stocks and Bonds?

By JLP | November 13, 2007

Are you as tired as I am of hearing about what percentage of your portfolio should be in bonds? It seems like lately there has been a plethora of articles outlining guidelines and suggestions on the allocation of stocks vs. bonds, especially in the wake of a huge focus on relatively new Target Retirement Date funds. These funds allocate your portfolio between stocks and bonds based on your estimated retirement date.

First of all, every investor has a unique time horizen and risk tolerance, so any rule of thumb is hardly adequate. Secondly, I think the typical rules of thumb are too conservative anyway. Many people are now living well into their 90s–and a recent article in Time suggests that some women in their 20s today may live to be over 120. Additionally, careers and aspirations are changing. Few folks can or want to quit earning income and live totally off of their retirement funds at 65.

So the method of “subtract your age from 100″ or even from 115 to get the percentage of your portfolio that should be in bonds seems rather outdated. Target Retirement Date funds that allocate half of a middle aged person’s portfolio to bonds can actually be much too conservative, especially if that person has significant short-term assets outside of their retirement portfolio or if they expect to have other sources of income past age 65 such as pensions, passive income, earned income, or social security.

And yet funds that allocate smaller percentages to bonds are labled “aggressive” or even “very aggressive” which can confuse and scare away investors who wouldn’t categorize themselves with those lables. Words like “balanced” describe funds with upwards of 35% in bonds–which can actually be very conservative if you’re investing for the long haul.

I’m also particularly tired of all the articles that seem to come out of the woodwork when the market is “unstable” which ask, imply, or suggest that one should shift a larger percentage of their portfolio to bonds. Just yesterday a commenter suggested that I shift a third of my stock holdings into bonds.

Last time I checked, selling stocks when the market goes down is NOT the best way to maximize your return. Isn’t “buy low, sell high” supposed to be the goal? Besides, your allocation decision shouldn’t have anything to do with what’s going on in the market in the short term. Or perhaps I just missed the memo announcing that the media has suddenly gotten really good at predicting the market.

Personally, I don’t think ANY significant percentage of my retirement portfolio should be in bonds. I have almost 4 decades before I am legally supposed to touch my 401k or IRA. And even then, I plan to have enough “passive” income to keep me from having to totally live off my retirement funds. Plus, basically all of my non-retirement funds are in cash or bonds.

What’s your view on the stocks vs. bonds debate? What factors should determine your asset allocation?

More from Meg at The World of Wealth

Topics: Asset Allocation, Bonds, Retirement Planning | 22 Comments »


22 Responses to “The “Right Mix” of Stocks and Bonds?”

  1. Jeremy Says:
    November 13th, 2007 at 9:23 pm

    Well, as you said, all of the rules of thumb that get thrown out there are pretty wild speculation and don’t really address anyone’s personal situation, so they aren’t worth much. And also, it is always funny when the media begins to tout bonds as soon as the market takes a turn. They are basically encouraging people to sell on a knee-jerk reaction to a short-term fluctuation that makes them actually lose money.

    All that aside, I think the right kind of bonds can have a huge impact on even a young person’s portfolio. But, unfortunately bonds get a bad rap. They are portrayed as conservative intermediate to long-term government or AAA rated bonds used for security, spewing out returns that barely keep up with inflation. There is so much more to investing in bonds, but they are almost always simply used for downside protection.

    There are plenty of high-yield bond strategies and funds that can be almost as volatile as stocks and even occasionally turn out 10-20% annual returns.

    Like you, I have decades until I need any retirement income, so I don’t really need bonds as part of a downside protection part of my portfolio, yet I still hold typically upwards of 40% bonds overall.

    Almost all of these bonds are in various higher risk categories, but they play a key role. They generate income, which then gets reinvested. The average yield of my bond holdings is a touch over 7%. So whether the stock market is going up, down, or sideways, part my portfolio is generating income, which automatically gets reinvested. Every quarter or six months, that reinvested income into the bond fund makes the bond holdings out of whack with my target allocation, so those earnings then just get reinvested into the stock holdings.

    So my bonds aren’t protecting me from volatility in the market as much as earning income which is eventually applied to build up my other investments automatically. Sure, the underlying value of the bond fund might decline in value when the stock market is tanking, but that is fine, since I’m just using the income they generate to DCA across other investments.

    Of course, this is just my strategy and not suitable for everyone. But I agree, bonds and their use in asset allocation are very conservative estimates which shouldn’t be followed too closely, but not all bonds are what you picture your grandparents buying in order to fund their retirement.

  2. joewatch Says:
    November 13th, 2007 at 9:44 pm

    The rule-of-thumb that is recommended by John Bogle is to hold your age as a % of the bond portfolio. The older you are, the more in bonds you should have. The type of bonds that you should hold are intermediate high-quality bonds (10-15 year bonds AAA rated, or treasuries.) Long-term bonds may yield more, but the risk to capital if you hold them in a bond fund is usually not compensated sufficiently.

    For people who are less than 40 years, I think it’s absolutely reasonable to have a 100% stock portfolio, because you have plenty of time to ride out any rocky periods (like the one we’re having now.) However, as you near retirement, you no longer have that luxury, and you need a stablilize your investments by putting more of your money into fixed-income investments.

  3. NCN Says:
    November 13th, 2007 at 10:50 pm

    I struggle to find the right balance –
    Right now, I’m just putting most of my retirement savings in a simple, broad market, Index ETF…
    NCN

  4. Swim Upstream to Wealth Says:
    November 13th, 2007 at 11:17 pm

    The question of how much in bonds come down to your risk capacity. It doesn’t matter if you are 20 or 50. I have seen young folks who lost a ton in the tech bust go to all fixed income because they got so freaked out after the huge losses. Sure, it was an unwise move, but they should have had a percentage in bonds to mitigate their true risk capacity.

    I have known folks over age 50 who are more aggressive than most 20 year olds. Usually, these folks are entrepreneurs or natural risk takers, but they can handle the volatility.

    What folks need to realize is asset allocation deals more with engineering than art. By looking at the standard deviation of a portfolio, you can get a feel for your downside risk in your portfolio. If the downside scares you, add bonds. If not, go play golf or spend time with family and let your portfolio work for you.

    As far as which type of bonds, I prefer high quality. If I am investing in bonds, then I am attempting to minimize my portfolio volatility. Junk bonds are as risky as equities, but more tax inefficient.

  5. Andy Says:
    November 14th, 2007 at 12:20 am

    I think it is appropriate for almost every investor to have some amount in bonds. The worst thing that can happen is if an investor is scared by a downturn and stops investing. It’s much better to have a 60/40 or 75/25 allocation that you can stick with than a 100% equity allocation that you flee from after a bear market.

  6. Dave Says:
    November 14th, 2007 at 10:17 am

    I didn’t have any bonds in my portfolio until I turned 55. Over the next 5 years, I moved 5% per year from stocks to bonds. Now, at age 65, I have a 25% allocation in bonds, which I expect to continue to maintain for many years. A monte-carlo portfolio analysis tool shows that 75% stocks and 25% bonds provides about the best possibility of portfolio survival for 30 years.

  7. Don Says:
    November 14th, 2007 at 10:18 am

    I’m one of those people that believes you have bonds in your portfolio to reduce volatility. If you really believe and understand that, though, you can’t really count your non-retirement funds the same way.

    Unless you plan to use your non-retirement funds to rebalance (i.e. to buy more stock if the stock market tanks) then it isn’t really reducing volatility. The only assets that reduce your volatility in a significant way are those you rebalance with.

    I take it as tacit assumption that you rebalance of course. If you don’t rebalance, then you aren’t really getting the reduction of risk you think you are. Yes, you prevent your portfolio from “going to zero,” but that’s not quite the same as reducing volatility. You could own an ETF of the Wilshire 5000, all stock, and be pretty much guaranteed that your investment would never go to zero.

  8. Cory Says:
    November 14th, 2007 at 10:43 am

    I’m 22 years old, have 100% of my portfolio in stock, and absolutely no plans to add for at least 20-30 years.

  9. Cory Says:
    November 14th, 2007 at 10:43 am

    “to add bonds”

  10. LegalTherapy Says:
    November 14th, 2007 at 11:09 am

    I’m in my late 20’s. I contribute the max to my 401K annually and I put extra money (i.e., money I don’t expect to touch for at least 10 yrs) in index funds in a regular brokerage account. Total percent I put in bonds? 0%.

    If my investing horizon is 30+ yrs, why would I buy into an asset class with lower returns than stocks? Except as a place to keep short term cash fairly liquid, I don’t think I’d buy bonds until my mid-40’s at the earliest.

  11. muddlehead Says:
    November 14th, 2007 at 11:44 am

    don’t even think about bonds (i use cd’s myself for bond portion allocation – cause the additional interest bonds pay not enough compensation for the hassle of worrying about a company’s solvency) until you’re on the back nine, or age 55, like dave said, or real close to retirement. until then, buy a home, dollar cost avg into no load total stock market index fund, work and save as much as you can.

  12. FinanceIsPersonal.com Says:
    November 14th, 2007 at 3:27 pm

    I have my Roth IRA invested into Vanguard’s 2050 retirement fund, right now it’s 90% stocks and 10% bonds, by the time I retire, I think it’ll be 50%/50%, which is a pretty good mix, but I’ve always been a bit of a conservative type.

  13. Meg Says:
    November 14th, 2007 at 3:50 pm

    Thanks for all the great comments!

    Jeremy-thanks for pointing out the value of bonds themselves, not just as downside protectors.

    Swim Upstream–it certainly is more about risk capacity than age. If you’re 60 and extremelly wealthy and/or earning boatloads of income, you might not want much in bonds. If you’re 20 and very risk averse, you might want almost all of it in fixed income. To each his own.

    Don–good point about rebalancing. I don’t/wouldn’t use them to rebalance, so maybe that’s part of why I’m not too keen on having bonds.

    And to all you other young folks with nothing or little in bonds in your portfolio, I’m right there with you. Though I do keep my real estate reserves in bonds as a hedge and as emergency funds. It’s not that bonds are a bad idea, it’s just that you have to know WHY you’re investing in them–or not.

  14. sam Says:
    November 14th, 2007 at 3:52 pm

    Meg,
    I agree with you that Target Retirement Date funds can be too conservative. My wife and I are in our early 50’s and have our 401k contributions going into a 2040 retirement date fund, even though we will be eligible to retire in less than 5 years. The 2040 fund has 15% going into corporate and government bonds. That is compared with the 2010 fund that has 50% going into bonds. That is way too conservative for us.

    In response to some of the commenters above, a small amount of bonds in your portfolio (10 to 20%)can reduce the volatility of your investment without substantially reducing your returns in the long run. It may seem counterintuitive, but the bonds keep on providing returns even in a bear market for stocks. Something to consider. I used to have all of my 401k in stock funds, mostly S&P500, but after watching it lose a third of its value in the 2000-2003 time period, I change my strategy and started including small amounts of bonds in the mix.

  15. Dave2 Says:
    November 16th, 2007 at 2:54 pm

    I feel like most people only look at this issue from the contribution side of the equation. Equal consideration needs to be given to portfolio survival immediately prior to and during retirement. Dave touched on this above.

    Consider that during the contribution phase a 35% loss doesn’t really affect the long-term portfolio performance. During retirement however a 35% loss can be catastrophic, especially if it occurs early on in retirement.

    Required reading:
    http://www.fundadvice.com/articles/retirement/retirees-earn-lower-returns.-have-more-money..html

    http://www.fundadvice.com/articles/retirement/retirement-when-your-portfolio-starts-paying-you-.html

  16. Ryan Says:
    November 16th, 2007 at 5:08 pm

    Wow. I totally agree on the issue of semantics in these plans. My 24 year old friend picked a “conservative growth” fund for her 401k because she thought it matched her risk tolerance. I hurriedly looked up other funds described as conservative growth and they were all at least 40% bonds. Now she’s getting a personal finance book for Xmas :)

  17. Friday Finance Findings for November 16th : Generation X Finance Says:
    November 17th, 2007 at 9:54 pm

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  19. Phil A. Says:
    April 18th, 2008 at 10:27 pm

    I’m 29 years old and have 10% of my portfolio devoted to bonds. I’m opposed to an all stock portfolio. It just seems a little unwise to me. I believe in a little balance.

  20. Stephen Says:
    March 9th, 2009 at 4:59 pm

    Hey, just stopping by from the future. How did that “all stocks” thing work out for ya?

    Anyway, if you are young (like me) we should be able to weather the storm. Within a decade or so the market should have recovered all its losses. But they whole point of them “moving to bonds” as you get older is just in case the impossible happens: a 55% decline in the market.

  21. mack Says:
    July 3rd, 2009 at 5:29 am

    Thanks for sharing such great post on stocks and bonds, what i like is the Municipal bonds as they are exempt from all the taxes and interest earned on this bond is not subject to federal income taxes.

  22. lep Says:
    November 14th, 2010 at 12:54 pm

    I believe Jeremy’s comments (first comment) are the most salient. As you go through your career and age, you need to reinvest the yield earned from equities (stocks) and bonds. The goal at retirement is to have the highest monthly/quarterly income from equity dividends and corporate (and junk) bond distributions, not to have the highest dollar amount of your holdings.

    There is an optimum point that you can reach with yield vs. risk, and I believe this falls around 5-6%. Equities with annual dividend yields greater than say 7-8% have by design large payout ratios (e.g. REITS), or will eventually reduce their dividend. Take NLY (Annaly Capital) as an example, which yields a 15% monthly dividend. Most knowledgeable dividend investors would not touch NLY simply because of how they earn the high yield (purchasing mortgages and other high risk securities) — which does not have the characteristics of a wide economic moat. NLY is not like Coca Cola (KO), which has a very competitive product and is probably not going to lose out to a competitor overnight. Pepsi has been trying to beat Coke for years, however, when you travel overseas in Europe, S. America, Asia, Africa, Russia, you still see Coke everywhere. (ask for a Pepsi on an Alitalia flight in Italy). Back to the point, NLY does not have a wide economic moat and can suffer tremendously in a heartbeat when things go bad.

    As far as corporate bonds are concerned, you might invest maybe 40-50% of your portfolio in high-yield bond funds. Fidelity has several high-yield corporate bond mutual funds: Focused High Income (FHIFX), Strategic Income (FSICX), Capital & Income (FAGIX), and High-Income (SPHIX). These all yield 5-7% monthly distributions, and when reinvesting the monthly distributions over several decades, the result can be a quite high level of income at retirement. Mix this with the dividend payout for equities with yields in the range 5-8% that you reinvested for several decades and you should beat inflation.

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