Should I Invest in Bonds Even Though I Might Lose Money?

By in Asset Allocation, Bond, Investing, Reader Question, Retirement, Stocks | 18 comments

To Buy Bonds or Not to Buy Bonds; That is the Question

Reader question from Justin at Rootofgood.com

“I don’t know about the bonds.  Experts say put money in bonds.  I’m still almost 100 percent stocks although the market is getting high enough where I’m thinking about taking some profits.

I know I should have some bonds in my portfolio, but the rates are still near record lows.  Should I still invest in bonds, knowing there’s a decent chance I will lose money over the short to intermediate term?

When I was working, I had a stable enough income that I didn’t care if my portfolio swung 30 percent in a year, so I preferred the big returns of stocks.  Now that I’m retired, we are supposed to have some bonds to help with volatility, but I can’t pull the trigger and buy bonds that barely pay more than inflation.

Serious question, and I keep punting from making the decision.  :)”

Apart from the fact that Justin is in the enviable position of being 33 years old and retired, he’s asking a question that is a concern to many investors.

diversified stock and bond asset allocation portfolio

Understanding Bonds-The Backstory

Justin’s question is pertinent now because it is a certainty that when interest rates rise, bond principal values fall. That means anyone holding an individual bond or bond fund will experience a drop in value when interest rates go up. The amount of decline in the bond’s (or bond fund’s) value depends on the duration or average time to maturity. Higher duration bonds are more volatile than shorter term bonds.

On the flip side, as interest rates rise, dividends reinvested into a bond fund (or into new bond issues) will be reinvested at a lower price per share and with a higher coupon rate and higher yield.

So what is the investor, who wants a diversified investment portfolio to do?

I’ve been reading a lot about this topic, thinking about it for our family’s portfolio, and also discussing the issue with trusted colleagues in the finance world.

Given my findings, I’ll share several viewpoints and discuss the pros and cons, and then leave it up to you to decide.

Option 1: Continue with a 100% Stock Portfolio

Justin is in his early 30’s and I expect he is not living off the income from his investment portfolio.

Historically an all stock portfolio returned an average of about 9 percent per year.

If Justin has a high risk tolerance and can handle huge  portfolio declines, without selling, then an all stock portfolio might lead to the greatest long term returns.

But, be aware and don’t go into an all stock portfolio blindly.

In 2008 stocks lost 35 to 45 percent. A $10,000 portfolio falls to $5,500. In 2000 to 2002 stocks lost 40 percent in value. And in 1973 to 1974, stocks lost 37% of value.

Stock prices are very volatile, much more so than those of bonds.

Jay Yoder, the esteemed portfolio manger of the Smith and Vassar College endowments, answered the question, “Should You Invest Your Entire Portfolio in Stocks?” in an Investopedia article. Along with most investment professionals, Yoder recommends investing in a diversified portfolio, which includes bonds.

Even those of us with the strongest stomachs, don’t like to see our portfolio’s drop 40 percent. And you’ll find, due to the correlation between asset classes, that adding some bonds to an all stock portfolio won’t damage returns as much as you might expect.

Personally, I don’t suggest anyone but the most daring to invest in a 100 percent stock portfolio. It is too nerve racking and there’s no guarantee that the the future performance of assets will mirror the past.

Option 2: Get a sense of your risk tolerance and buy some bonds.

aronson marketwatch lazy portfolio

Marketwatch – Aronson Lazy Portfolio – http://www.marketwatch.com/lazyportfolio/portfolio/aronson-family-taxable

Set an allocation for your portfolio, in line with your risk tolerance, and stick with that asset allocation through thick and thin. If your fairly risk tolerant and young, you might only want 20 percent of your total investment portfolio invested in bond assets.

I’m a fan of the Paul B. Farrell’s Marketwatch Lazy Portfolio’s. Take a look at the Aronson portfolio above. This is a diversified low cost index fund portfolio with allocation to bond funds (corporates and Treasury’s), and U.S. and international stock funds.

Notice over the past 10 years that the S & P 500 returned 7.81 percent. Yet, the total Aronson portfolio return was 8.00 percent. In spite of the fact that the Aronson portfolio included corporate and US Treasury bond funds it still outperformed the return of the S & P 500. This recent ten year period disproved the belief that an all stock portfolio will always yield a higher return than more diversified stock and bond holdings.

According to Gregg S. Fisher, CFA, “Bonds Still Deserve a Place in the Portfolio”.

“As we see it, the purpose of bonds in an investment portfolio is not to generate high returns (the past 30 years of strong bond returns notwithstanding) but, rather, to dampen total portfolio volatility by balancing out such riskier holdings as equities and real estate. In particular, high-quality bonds like U.S. Treasuries generally help insulate a portfolio when stocks suddenly and unexpectedly plunge (notice that I do not include in this discussion high-yield bonds, which behave more like equities than like high-grade bonds).”

Over the long haul, a diversified portfolio which includes stocks and bonds will likely minimize volatility and offer an inflation beating return.

The short term outlook is unimportant if  you’re not going to need the funds until retirement. The portfolio’s short term volatility is the price you pay for the higher returns of participating in the investment markets.

Bond Investing Strategy Today

If you decide to add some bonds to your portfolio, many professionals (myself included) recommend keeping duration’s on the shorter end. Shorter duration bonds and funds are less volatile and as the short term bonds mature, their principal can be reinvested at the new lower prices with higher coupon yields.

I like John Bogle’s (founder of Vanguard Funds) approach to volatility, don’t look at the returns on your retirement portfolio until you’re getting close to retirement. And if you’re truly a long term investor, forget about the short term movements and business cycle ups and downs in your investment portfolio value.

 Investors, how your you allocating your portfolio in this rising interest rate environment?

 

 

 

 

    18 Comments

  1. Great advice with excellent perspective, Barbara! Some food for thought for me (and my investments).

    The advice on going short on maturity is important I think. At least when rates do rise, your bond fund principal won’t be hit as hard. What little fixed income we do have is actually cash with a duration of zero! Yields on cash in our money market are at 1%, so almost enough to cover inflation. In the next market downturn, we have enough to cover about a year’s expenses with the cash. It’s not a lot, but sitting on that much cash makes it easier to sleep at night knowing the other 97% of our portfolio can suffer those 30%+ losses.

    Justin @ Root of Good

    May 15, 2014

  2. @Justin, I concur that one can’t underestimate the power of cash. Even if the returns aren’t much, there’s nothing that replaces the liquidity when the unexpected happens.(And as of now, the future is tough to predict).

    Barbara Friedberg

    May 16, 2014

  3. Timely post thank you…I am late 50’s and financially independent today (tomorrow?) due to pension income and cash savings. Have a former workplace 401k about 60/40% stock/bond funds, built up over 30+ yrs of employment. Despite all the financial media doom & gloom buzz about bonds, it doesn’t seem prudent for me to sell off bond funds (PIMCO & Blackrock) or shift my general allocation at this point. My approach over past 30+ yrs was stay the course despite market ups/downs. Now that I no longer contribute to 401k or Roth IRA, should that affect how I manage the allocation/diversification?

    Stu

    May 17, 2014

  4. Has anyone read Nick Murray’s “Simple Wealth, Inevitable Wealth”, which makes a strong, reasoned argument for an all stock portfolio? What about Bogle’s using social security as a $350k inflation adjusted bond, which would permit one to have higher equity allocation? It seems many people who are purportedly “all stock” have two to three years of living expenses in cash, and are thus substantially hedged against downturns.

    Andy

    May 17, 2014

  5. @Stu, You are a man after my own heart, level headed. I absolutely agree with your position. As you currently have a pension, cash reserves, and will have SS in the future, it doesn’t seem as if you will need to dip into your investment portfolio in a major way. Is this correct? If that is the case, I agree with your position of “staying the course”. If you’ve had the fortitude to stay the course over the last 30 years, I’m confident you’ll be fine over the next 30.

    Barbara Friedberg

    May 17, 2014

  6. @Andy, Thanks for chiming in. I haven’t read Murray’s book, although I’m a supporter of Bogle. As Fisher mentioned (in the quote) in the article, bonds are helpful for one’s peace of mind. An all stock portfolio is extremely volatile, and one needs the fortitude to avoid selling when the markets go south and avoid going all in after a run up. Add that to the fact that no one knows the future, most people will feel more comfortable with broader asset class diversification.

    For the young and aggressive, there is a possibility that an all stock portfolio will offer the best long term returns, but in investing, there are no guarantees.

    How is your portfolio allocated Andy?

    Barbara Friedberg

    May 17, 2014

  7. Barbara, thank you for your support. You are correct…I do not need to dip into my deferred comp investment accounts in order to pay for living & modest travel/hobby expenses. That said, I am mulling over how/when to take deferred comp distributions with a purpose.

    Stu

    May 17, 2014

  8. @Stu, Are you referring to a retirement 401(k) or 403(b)? After saving for a lifetime, it takes a whole different focus to plan the “distribution” phase of life. If you don’t expect needing these funds for ordinary expenses, what are you planning on spending the deferred comp funds on?

    Barbara Friedberg

    May 18, 2014

  9. This is a great explanation of the options. I have had many of these concerns about bonds as well. My own solution to the problem has been to invest in a few, but mostly keeping stocks. At the moment, I can handle some volatility, but as I retire, I can see how the situation might change.

    The Wallet Doctor

    May 18, 2014

  10. Barbara, still a work in progress on how I intend to distribute & spend my 401k and Roth IRA accounts. One use may be to self-insure against long-term care expenses.

    Stu

    May 18, 2014

  11. @Wallet Doctor-An alternative I haven’t discussed in this article are some of the government’s offerings (at treasurydirect.com) such as I bonds, new floating rate notes (FRN), and maybe even a few TIPs. It sounds like you’re younger, so your aggressive stance makes sense.

    @Stu- Sounds like you’re weighing your alternatives and exploring some reasonable alternatives. Keep us posted!

    Barbara Friedberg

    May 18, 2014

  12. Stocks, Never. Short term bonds? Not for me. Go to FMSbonds.com and READ!!! Buy short term ONLY if you have a need at a specific date. I bought municipal bonds to mature for and during my Daughter’s college. Other than that I bought and buy (since 1984!) LONG term triple exempt Municipal Bonds. The interest rates are MUCH higher and then: BUY AND HOLD. They have made me rich. My coworkers lost nearly half of their retirement funds in 2001 and again in 2008. (Plus they will get to pay taxes and more taxes.) My bonds kept growing, some at 11.25% compounded semiannually. ZERO COUPON bonds grow and grow and for up to 30 years. No reinvestment required and no tax to pay. Barbara, email me. We need to put an article together.

    Randy C Hamilton

    May 19, 2014

  13. Hi Randy, Thanks for sharing your contrarian investment strategy. The problem with implementing your “only long term muni bonds” approach today is that at present, even yields on long term munis are quite low. In the 1980’s yields peaked in the low double digits. From 1981 on up until about the middle of the first decade of this century, yields were above the long term historical average of 5% (for long term treasury’s). If statistical principals prevail and we experience a reversion to the mean of bond yields, you can expect lowish long term bond yields going forward. But if safety is your concern, and the premium of munis over corporate bonds continues, it’s an interesting strategy. My preference for a 100% fixed rate strategy would be to invest heavily in I Treasury Bonds (Inflation protected). That would protect your capital from inflation.

    What type of yields are you getting on long term munis today (and for what term)?

    Barbara Friedberg

    May 19, 2014

    • I Bonds AFTER TAXES are crap. The Feds will see to that. 3.50 to 6.25% yield to maturity, triple exempt, are my last 4 purchases. All the best.

      Randy C Hamilton

      July 1, 2014

  14. @Randy, With you permission, I’d like to use your comment as a springboard for another bond versus stock investing article. What do you think?

    Barbara Friedberg

    May 19, 2014

    • Swell. What do we need to do?

      Randy C Hamilton

      July 1, 2014

  15. Hi Randy, I certainly can’t argue with triple tax exempt munis 3.5%-6.25% yield to maturity. Those are quite juicy yields!

    With reference to my prior request, are you interested in writing an article for me describing your muni bond strategy. I think my more advanced readers would appreciate your perspective. (sorry about the delayed response)

    barbara friedberg

    July 2, 2014

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