Let’s talk about bonds and your asset allocation.
For most investors, they have a love/hate relationship with bonds. As an example, in late 2021, most investors loved hating on poor old bonds. They had terrible returns, so why not? Legions of investors proclaimed that they were eliminating bonds from their asset allocation and going 100% stocks. And anyone who didn’t do the same was a wimp.
Fast forward 6 months and in summer 2022, investors kind of love bonds again. Especially I-bonds offering inflation adjusted returns…a nice benefit for a high inflation environment…
What’s the problem with this love/hate relationship?
Why not just seesaw along with bonds in your asset allocation like some kind of high school summer fling?
Well, because doing so is hazardous to your wealth.
If you hated bonds in late 2021, then you sold them. And you sold them cheap. When you loved them again in 2022, you bough them…high. Buying high and selling low is…well, it’s not good.
And again, no one has a crystal ball to predict when these changes are going to happen. If they did, those 100% stock allocation zealots would have maybe softened their position. Because they look less than clairvoyant only 6 months later.
This all means that, like it or not, you need to determine your asset allocation of bonds and stick to it.
Let’s talk about how to do that.
A refresher on bonds
A bond is basically an IOU from the government, a corporation, or other entity. You give them money and they promise you to give that amount of money back with a fixed interest rate at a later date (called the maturity of the bond, like 5 years, 7 years, or whatever).
In general, bonds are lower risk than stocks because you “buy” a largely fixed interest rate that you theoretically are guaranteed to receive if you hold the bond to maturity. Since it is lower risk and more stable, bonds generally have a lower return. But, stability and decreased risk play an important role in any investor’s portfolio.
Now, there are tons of different types of bonds. Treasury bonds, G bonds, inflation linked bonds like I-bonds or TIPS, corporate bonds, junk bonds, and so on. Within this range of bonds, some are riskier than others.
Junk bonds are bonds from companies that have a high risk of default. Thus, this risk carries a higher potential return. Meanwhile, the government is very low risk to default so risk and returns are lower with things like treasury bonds.
For the purposes of this post, let’s just say we are discussing generic U.S. government bonds to keep things simple.
Determining your asset allocation of bonds
There are 3 big important considerations when determining what percentage of bonds you want in your portfolio.
1. Your risk tolerance
This is #1. Remember, with anything in investing, increased risk should be compensated with higher potential returns. That is why stocks in general have higher potential returns than bonds.
But, that doesn’t mean stocks are always better than bonds. Remember, stocks are more volatile and riskier. Even low cost, broadly diversified index funds. There have been periods of time where bonds outperformed stocks.
Think of bonds like the ballast of your investment ship. Yes, it weighs the ship down. But just enough to keep it steady and keep you on course, afloat, and moving forward.
The lower your risk tolerance, the higher your asset allocation of bonds should be.
It doesn’t matter if a 100% stock allocation will theoretically give you higher long term returns if you sell them during the first bear market you experience because you can’t handle the roller coaster. Placing a portion of your portfolio in bond to protect this from happening is well worth it.
2. Your time horizon
I recently wrote a post about the role of luck in personal finance. In our Facebook group, one member commented that it was bad luck that her child was starting college funded by a 529 account during a stock market correction.
Managed properly, I actually don’t think this is bad luck.
As the child reached closer and closer to college age, the proportion of bonds in the 529 account should have been increased to near or at 100%. Then, the stock market correction would have a much more minimal impact.
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In this situation, when the child is about to start college, the goal for the 529 account is not to generate huge returns through relatively riskier investments (like stocks). The goal is to preserve the capital there to fund their college education. Bonds accomplish this task.
This same logic applies to your retirement
The longer your time horizon until you retire (and are going to actually start living on your nest egg), the more time you have to wait out the short term fluctuations of higher risk, higher potential return investments like stocks.
Early in your investing career, your goal is to grow your investments.
The shorter your time horizon, the more your goal becomes protecting the investments that you have. If you have a 100% stock allocation when you retire and a bear market hits, you are in trouble. However, an 80% bond/20% stock allocation is much better able to weather the storm and support your retirement at the same time.
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3. Diversification
Stocks and bonds are imperfectly correlated. Meaning that they don’t respond and move in tandem.
Sometimes one zigs and the other zags. And vice versa.
You want elements of diversification in your portfolio to protect you from too much zigging or zagging in one direction by one of your investment vehicles.
With these three factors laid out, let’s move on…
How to figure out your own bond asset allocation
Now that we understand the theory behind bonds and their purpose(s) in an investment portfolio, how can you figure out the right number for you. Because it will be unique to each investor.
And there is no right answer as long as it fits your risk tolerance, time horizon, and need for diversification.
1. Start with a rule of thumb
Like all rules of thumb, this is totally arbitrary but somehow works out.
Take your age and round down to the nearest 10. For example, I’m currently 34 so I would round down to 30.
That number now represents my ideal bond percentage for my portfolio. 30%.
2. Now tweak it as needed
Again, it’s a rule of thumb that a proven theorem of some kind. So take this asset allocation as a starting point and adjust as necessary.
My advice would be to stay within +/- 10% of that number to begin. If you realize after a bit that your risk tolerance or time horizon is much bigger/longer than initially estimated, adjust more at that time.
For instance, my ideal allocation is 30% bonds. But in reality, my financial plan calls for 20% bonds as my time horizon is pretty long and risk tolerance is moderate.
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3. Stick to it and rebalance yearly
Resist the urge to time the bond market. Resist people telling you that bonds suck and you are silly for holding them.
No one can predict the future. And your bonds are serving a purpose. So trust the process and keep the course.
What to do if you need to change your asset allocation of bonds
Let’s say that you are not just determining your asset allocation for the first time. You already have one and need to make an adjustment. Maybe you have too much in bonds? Or too little? What should you do?
The best thing to do is to simply buy more of whatever you need to reach your new asset allocation when you contribute money to your investment portfolio.
For example, if you have a 50% stock/50% bond portfolio and want it to actually be 80% stocks/20% bonds, just buy more stocks with your investment contributions until you reach the 80/20 split.
You could of course sell bonds (stocks) and buy stocks (bonds) as needed within your portfolio to even things out. But this will trigger fees as well as taxes if not in a tax advantaged retirement account.
Lastly, let’s say that a bear market convinces you that you need more bonds and less stocks in your asset allocation. This is not a good time to sell stocks in order to buy bonds and adjust the split. Either just buy bonds until you reach your new goal allocation without selling stocks or wait for some recovery/stability in the market.
Your personal financial plan
Determining your asset allocation of stocks and bonds is a huge step in creating and solidifying a personal financial plan. If you don’t yet have one, it’s time to create one. You can learn how with my course or even use my written financial plan as a guide!
What do you think? What percentage of bonds is in your portfolio? Are they serving the right purpose? How do you adjust them? Let me know in the comments below!
jordan good post man š just a correction though the dude (or dudette) that sold bonds at the end of 2021 was actually selling high given low interest rates, and then if they bought just recently was buying bonds low after rising interest rates pounded bond values into the ground.
but your point remains- the dude/dudette just got lucky and could not have predicted in hindsight where interest rates and therefore bond values were headed.
a more interesting question and would love to hear your thoughts is if you think bonds should be looked at as riskier when interest rates are close to 0 like they were 8 months ago? The potential volatility risk of bonds at the low end of the yield curve is exponential, as we saw during these past few months where bonds, even treasuries with short duration, were taking stock like losses! should we consider bonds more risky during low interest rate environments, and may shift to some of our asset allocation from bonds to cash to more appropriately reflect our risk tolerance?
Hey Rikki, thanks for reading! You are totally right about the example in the timeframe but was just laying it out as an illustration. You make an interesting point about bonds in low interest rate environments. In theory it makes sense if we are able to accurately predict rate movements. In the end, my philosophy is generally that simple is better so I keep my bond allocation stable according to my plan rather than move it around.