Thursday, December 24, 2009

The Purpose of a Bond Allocation in Your Portfolio

If the long-term return on stocks is 8-11% and the long-term return on bonds is 4-6%, why should I own any bonds?

This question is often asked by folks condition by the bull markets of the golden decades of the 1980's and 1990's into thinking that the road to wealth lies in being 100% invested in stocks, and that bonds are a loser's game. After the tin decade of the 2000's, where bonds returned around 5% a year and stocks around -1.5% a year, the wise advice that your bond allocation should come close to matching your age might be more apparent. The emotion turmoil of the financial market meltdown of 2008-2009 caused many people to sell low once their pain threshold for losses had been crossed only to see the market rebound months later. My preferred portfolio allocation for almost all investors is the traditional 60/40 split between stocks and bonds to balance growth and stability.  The primary reasons for having bonds are:
  1. Risk Management.  When generational bear markets hit like 2008-2009, your bond allocation will limit your downside, provide more stability, and make it easier emotionally to stay the course with your investment plan.  Bonds have a lower volatility than stocks, and the shorter the bond duration the less the volatility.
  2. Low Correlation between asset classes.  Bonds and stocks often move in opposite directions, and are influenced by different factors in the economy.
  3. Steady, reliable compounding of income. 
  4. No one knows what the future holds. 
People will not get rich off of bond investing, but mixed with stocks in a balanced portfolio they help provide stability and the right overall asset mix can come close to approximating the overall return of the market with less volatility enabling investors to sleep better at night.

Some passive bond funds that I like currently include the usual suspects: Vanguard Total Bond Market Index, Vanguard Intermediate Term Bond Index, and Vanguard Short Term Bond Index.  Active funds that I like are Dodge & Cox Income, Harbor Bond Fund Institutional, and for the more risk tolerant Lomis Sayles Bond Fund and TCW Total Return Bond.

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