I recently wrote why you need bonds in your portfolio. I do have a confession to make, in my retirement accounts, I invest 100% in stocks. Before you call me a hypocrite, let me explain two things.
- Recall the qualifiers I used before telling you that investing 100% in stocks is a bad idea.
- I am specific in saying I invest 100% in stocks in my retirement accounts. I do have bonds in my investing accounts that have a shorter time horizon than retirement.
When I made the case as to why you need to have some of your portfolio allocated to bonds, I outlined the conditions necessary for a 100% stock portfolio to make sense. If you are:
- Under 30 with a multi-decade investing time horizon
- Know what you are doing
- Can handle short term volatility
I feel that I meet all of these criteria. In addition to that, both my wife and I have a Defined Benefit (DB) pension plan through work. A DB pension provides a guaranteed level of income during retirement, This allows me to be much more aggressive with my personal investments.
Additionally given I am 31, I won’t be withdrawing from my retirement account for multiple decades. That means that if the market were to drop by 40% tomorrow I could withstand that level of short term volatility. It would not feel nice, in fact, it may make me feel sick to my stomach. But, I know I’d have more than enough time to make up for any short term losses in my retirement accounts.
Since the expected returns of stocks are higher than bonds, the only reason I would have as a 31-year-old to invest my long term money in bonds was if I believed the stock market was about to crash as it did in 2008-2009. I’ll use this as my worst-case scenario.
First, loading up on bonds in anticipation of a market crash would be a form of market timing. Those who believe they can time the market will load up on assets with a low correlation to stocks when they anticipate a market will crash. The thinking goes, that they can then buy into stocks after the crash and ride the wave of future gains as the market recovers.
Market timing is a nice story. However, research suggests that the stock market is efficient. If the stock market is efficient, all available information will be reflected in stock prices. I’ll put it simply. If you believe that the stock market is about to crash, there will be other investors that think the same way. That means the risk of a market crash will be reflected in current stock prices.
The fact that risks are factored into stock prices, does not make it any more or less likely that something could happen in the global economy to cause a market crash. That brings me to the second reason my retirement portfolio is invested 100% in stocks.
My investment timeline allows me to withstand short term volatility. Let’s say I was 31 years old on the eve of the financial crisis and I had 100% of my retirement portfolio invested in the S&P 500.
- If my portfolio was worth $100,000 in September 2007
- By January 2009, my portfolio would be worth about $51,000.
- Nearly half of my portfolio would be wiped out by the time I was 33.
- By 2019, even if I had never invested another dollar into the market my portfolio would be worth around $160,000
- That’s a nearly 60% increase while investing at the worst possible time.
- By this point, I would be 43 and allocating more of my portfolio to bonds.
Given my comfort with risk and my time horizon until retirement, I am comfortable allocating 100% of my retirement portfolio into stocks.
Why you should invest in bonds
If you don’t have a multi-decade time horizon to retirement or you aren’t comfortable with massive short term volatility than you absolutely need to allocate a chunk of your portfolio into bonds. How much, will depend on a number of factors including your total retirement assets, years to retirement, the amount of income you need to replace and comfort with risk.
Perhaps the most critical thing for you to consider is your comfort with risk. A lot of people got spooked during the financial crisis and sold at the bottom of the market. This turned “paper losses” into real losses and their retirement nest egg never recovered.
If you are worried about that type of volatility then bonds can help smooth the ride. Vanguard has studied the best and worst years for asset allocations that range from 100% bonds to 100% stocks.
- In it’s worst year, the 100% stock portfolio lost 43.1% of its value (in 1931)
- In that same year, 1931, a portfolio with a 60% stock-40% bond allocation would have only lost 26%. Still no picnic, but not nearly as terrifying as the 100% stock portfolio.
How much should you have in Bonds?
Bonds and in particular high-quality government bonds have a low or even negative correlation with stocks during market downturns. The standard stock-bond allocation for a diversified portfolio has been a 60-40 split between stocks and bonds. Historically, a 60-40 bond allocation has done quite well. The average annual return of a 60-40 portfolio in U.S stocks and government bonds was over 9% since 1928. This is the “total return” meaning it included dividends and bond interest and is not adjusted for inflation.
If a 60-40 allocation feels a bit arbitrary another handy rule of thumb is the rule of 110.
The rule of 110 is a rule of thumb that says the percentage of your money invested in stocks should be equal to 110 minus your age.
- If you are 30 years old the rule of 110 states you should have 80% (110–30) of your money invested in stocks and 20% invested in bonds.
- If you are 50 years old, the rule states you should have 60% of your money invested in stocks and 40% invested in bonds
The idea is rather simple. The younger you are, the longer you have until retirement and are better able to recover from downturns in the market. When you are young, you are in what’s called the wealth “accumulation” phase. You are trying to build as much wealth during your prime working years as possible.
When you are near or in retirement, your objectives and relationship to risk will change. In retirement, you are living off your nest-egg and if the market drops while you are withdrawing from your portfolio it could seriously jeopardize your retirement. That’s why it makes sense to shift from wealth creation to wealth retention. Which means investing more heavily in bonds and other low-risk assets.
Right now I still have 100% of my retirement portfolio in stocks. As I get older I will become much more conservative and begin allocating more of my portfolio to bonds.
What kind of allocation do you have towards stocks and bonds and what factors did you consider? Let me know in the comments.