Why You Need Bonds in Your Portfolio

While there are limited circumstances when a 100% stock portfolio makes sense, most of us should be invested in a diversified portfolio of stocks and bonds.

I believe you need bonds in your portfolio. But 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. 

1. Recall the qualifiers I used before telling you that investing 100% in stocks is a bad idea.
2. 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. 

You may not need bonds in your portfolio

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.

Avoid market timing

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 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 to stocks. 

Why you should invest in bonds 

Suppose you don’t have a multi-decade time horizon to retirement, or you aren’t comfortable with massive short-term volatility. In that case, you need to allocate a chunk of your portfolio to bonds. The portion will depend on a number of factors, including your total retirement assets, years to retirement, the income you need to replace, and your risk tolerance. 

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.

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 its 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, this allocation has done quite well. The average annual return of a 60-40 U.S. stocks and government bonds portfolio 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

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.

Consider Series I Bonds

If you’re looking for higher interest rates than what you’ll commonly find available in traditional bank accounts, you may want to consider the role Series I Savings Bonds can play in your portfolio. 

Series I Savings Bonds are low-risk savings products offered by the U.S. Government that pay interest and provide inflation protection. To learn more about this timely opportunity and if I Bonds may be right for you, consider listening to this episode of the Retirement Revealed Podcast hosted by financial advisor Jeremy Keil. You’ll also find updates published at this link with current interest rate details and useful insights to help you learn more.

How do financial experts recommend their clients allocate to bonds?

We asked financial advisors in the Wealthtender community how they suggest their clients invest in bonds. Here’s what they said:

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“There are two methods I find that work well for determining an ideal bond allocation for a client. One method is based on risk tolerance & rate of return requirements; for these clients, we use historical returns of portfolios and help clients match their risk tolerance (using a questionnaire that scores more risky answers with more points). A second method is based on cash flow analysis and liability matching. For these clients, we start by designing the bond allocation as a series of maturing bonds (a bond ladder) that meet the client’s expected spending rate for necessary expenses. For non-essential expenses, we can rely on dividends & stock appreciation. Sheltering enough in bonds to help protect the necessary expenses helps investors sleep better at night.” – Doug “Buddy” Amis, CEO of Cardinal Retirement Planning.

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“I decide on a recommended bond allocation based on a client’s risk tolerance and when they will need the money. If they have a lower risk tolerance, I may up the bond allocation. Also, as we approach their need for the money, I will recommend we move more money to bonds or cash. Many of my clients are military or former military who may have a pension. In those cases, I do recommend they hold less in bonds and view their pension as a portion of their fixed-income needs.” – Mike Hunsberger, ChFC, CFP, founder of Next Mission Financial Planning.

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“We determine a client’s bond allocation based on two factors. First, we set up a short-term bond account that holds 3-5 years of a client’s expected retirement spending. These are all short-term, investment-grade bonds in a laddered structure. Second, we add a diversified bond allocation to the client’s longer-term portfolio. This is based on the amount of remaining bonds necessary to keep the client’s overall allocation in line with their strategic asset allocation target based on their risk profile.” – David Edmisten, CFP, Founder, Next Phase Financial Planning.

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“At Arch Financial Planning, we use Monte Carlo simulations through financial planning software to determine the client’s appropriate allocation needed to meet their goals. Next, we review potential drawdowns for the allocation determined through retirement planning to ensure the client’s risk tolerance is considered.” – Cecil Staton, CFP, CSLP, Founder of Arch Financial Planning.

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“Now that inflation has likely peaked, and interest rates are meaningfully higher, investors need to reassess the role bonds play in their portfolios. With investment-grade corporate bond funds yielding over 5%, savers will not need to take on additional equity risk to hit goals. Investors that need to hit 8.00%-9.00% to reach goals will not need to take on that additional equity risk they needed to in years past.” –  Ryan Graves, CFA, President of Bemiston Asset Management.

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“How much money do they need in their ‘war chest?’ I describe that the markets go up and down, and we need money set aside, outside of the stock market, that we can tap into in case something happens personally in your life or if you plan to tap into for income while the markets are down, assuming you are living off of your investments. How many months/years of expenses would you need in your war chest to feel comfortable? Then, they can tell me how much. If it’s a huge number, then I will educate them on the pros/cons of having too much out of the stock market.

“Once the war chest is agreed upon, then we figure out how much volatility they would be willing to accept with the rest of the money. For example, if I’m working with a retired client, and we put five years in the war chest (bond ladders, cash, etc.), then we might be 100% stock or less in their other buckets, depending on their feelings around risk.

“Generally speaking, for retirees, I suggest five years of expenses in bonds as a starting point. For younger people that are far from retirement (at least ten years) and are in their earning years, that amount could be as little as 3-12 months of expenses.” – Zack Swad, President & Wealth Manager of Swad Wealth Management.

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“I work with clients to determine their risk level and their goals for their money. Then I will run a Monte Carlo simulation. Finally, with this combination of information, I choose the percentage that should be in bonds.” – Nathan Mueller, MBA, founder of BlackBird Finance.

Bottom Line

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?