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Having bonds in your portfolio is a great way to add diversification. But are you wasting your time in money investing in bonds?
When you invest in a bond, you lend money to the government or a company and receive interest in return.
You get to pocket the interest and also receive your initial investment when the bond matures (bond interest is not the same as dividends from a stock).
Bonds usually yield a low rate of return, much lower than stocks. That is why before you invest in bonds, you need to make sure that you need them. If you don’t need bonds but have them in your portfolio, you may be settling for a lower return on your investment.
By the end of this article, you will be able to decide for yourself if you need to include bonds in your portfolio.
Do I need bonds in my portfolio?
Various factors decipher whether or not you should include bonds in your investment portfolio. Such factors include your ability to tolerate risk, the number of years you have until retirement, and the type of brokerage account you have.
1. Determine Your Risk Appetite
Think of bonds as a tool you can use to decrease risk and volatility in your portfolio. Because bonds are much less volatile than stocks, including bonds will lessen any drawdowns your portfolio goes through. Therefore, to determine how much of your portfolio you want to allocate to bonds, you must first assess your ability to take risk. The less willing you are to take risk, the more you can allocate to bonds.
Let me give you an example to help you with that.
The year is 2007. You heard stories about people making money in the stock market, so you decide to give it a shot. You transfer $10,000 of your hard-earned money from your savings account into your brokerage account and invest in a S&P 500 index fund for the long term.
Then, the housing market crash happens. No matter where you go, all you hear is negative news about how the stock market is going to crash. You nervously check on the stock market’s performance every single day, and it keeps going down. You check on your investment portfolio and you witness your hard-earned money seemingly vanish day by day.
How big of a drawdown on your portfolio would you psychologically be able to handle? 10%? 20%?
The S&P 500 lost approximately 50% of its total value during the housing market crash of 2008. In other words, out of the $10,000 you invested, you would only be left with $5,000. It would also have taken you 17 months to recoup from those losses.
Historically, the stock market has recovered 100% of the time. But would you have been able to hold through such a volatile market? Or would have ended up selling for a loss? This is why you must assess your risk appetite.
If you think you’d have trouble holding through such a volatile market, adding bonds would decrease the drawdown. Let’s take a look at different asset allocations you could combine to decrease the drawdown of your portfolio.
We already know that a 100% stock portfolio would have caused a 50% drawdown. Now, let’s take a look at a portfolio with a stock/ratio of 90/10 during the same crash. The following information is provided by Portfolio Visualizer.
By allocating 10% of your portfolio to bonds, you would have decreased the drawdown by approximately 5%.
Now let’s take a look at a portfolio with a 70/30 ratio.
During the same period, the 70/30 portfolio only experienced a drawdown of 33.91%, compared to 50%.
I cannot tell you the exact percentage you need to allocate to bonds because there is no right answer. This is a personal decision you must make after assessing your ability to handle risk.
One thing that can help you decide is to remember that the “dampening” characteristic of bonds works both ways. Bonds may lessen the drawdown, but also lessen the upside potential for your portfolio because stocks have historically yielded much higher than bonds. The more you allocate to bonds, the more stable and less volatile your portfolio will be. But during bull markets, the less your portfolio will gain.
Are you willing to take on more risk/volatility for more profit? Or are you more risk-averse, preferring to sacrifice some upside in exchange for peace of mind?
2. Calculate The Number Of Years You Have Until Retirement
The percentage of bonds in your portfolio can also be determined by how many years you have until retirement. Investing in the stock market is a long-term game. The longer you remain invested, the less risk you have of losing money. Therefore, the longer you have until retirement, the more you can afford to invest in the stock market.
Take a look at the chart below provided by Rinkydoo Finance.
If you have one year until retirement, you wouldn’t be able to invest a whole chunk of money into the stock market. With a 1/4 chance of facing a losing year, your retirement would be in jeopardy – the majority of your portfolio would need to be in bonds.
On the other hand, if you have 10+ years until you retire, you can afford to take more risk. If the stock market goes through a correction, you have much more time to allow the market to recover.
Some recommend subtracting your age from 100 to find the percentage of your portfolio you should have in stocks. For example, a 20-year-old should allocate 80% of their portfolio to stocks and 20% to bonds
100 – 20yrs. old = 80% stocks
You never know when the stock market will enter a bull market or when it will go through another crash. If you are closer to retirement, make sure you are choosing an asset allocation that can withstand a crash and still allow for you to retire.
3. Consider The Type Of Account You Have – Taxable or Tax-Advantaged?
It is important to buy bonds in a tax-advantaged account. The interest you receive from almost any type of bond, with the exception of municipal bonds, is taxable. If you were to invest in bonds in a regular brokerage account, you will be taxed every time the bond pays out interest. However, by investing with a tax-advantaged account, you can shelter your bonds from being taxed.
Here are some tax-advantaged accounts you can open: Roth IRA, Traditional IRA, 401k.
I recommend checking with your brokerage if you want to buy bonds, but don’t have a tax-advantaged account.
Make sure to take advantage of this tax exemption!
Conclusion
Whether or not you choose to have bonds in your portfolio, you must consider your ability to handle risk, the number of years you have until retirement, and the type of investment account you have.
Remember, bonds are a tool to dampen volatility. They make it easier to hold through bear markets, but holding too much bonds will bring down the expected returns of your portfolio.
What is your bond asset allocation?