When people discuss investments, many talk about “trendy” stocks: tech giants like Apple, or maybe Amazon or Tesla, and so on. But don’t we all also have that one friend who brags about their well-diversified bond portfolio? (Kidding, of course.)
Let’s face it. Many investors perceive bonds as boring investment vehicles compared to a stock like Apple, so you don’t hear much about them during casual conversation. A primary reason that they are boring is their structure: bonds are essentially a loan between you and another party (whether it’s a company or some unit of the government). In exchange for your money today, the issuer promises to pay you interest (the yield) for the life of the bond, plus the principal (i.e., your money back) at the end of the term. Because of this relatively safe structure, bonds generally lack the potential reward that stocks or stock mutual funds provide.
So if bonds are “boring” investments, what role do they play in a thoughtful investment portfolio? In this article, I’ll share a few of the key reasons why it’s important for many investors to own bonds.
As a Safety Net for Specific Goals
Imagine saving over many years for a down payment on a home, or for retirement, then having to postpone because the market suddenly dropped. March of this year was a good reminder that stock market volatility is an inevitable part of long-term investing.
When we start working with a new client, we adopt the mindset that it’s the beginning of a multi-decade relationship. Our first priority is learning our clients’ goals by asking questions. Common examples of such questions include:
- Do you want to accumulate a specific amount of money over your lifetime and leave a legacy for your children?
- How do you want to spend your retirement?
- Do you want to donate a certain amount to charity, either annually or at your passing?
- For younger clients: Are you saving to purchase a new home?
Once we understand our clients’ goals, we try to find an appropriate asset allocation to reach those goals with as little risk as practical. We are often cautious with a portion of their funds, as we don’t want money that is earmarked for a near-term goal to be exposed to a sudden, unforeseen market drop. Because they lack the volatility of stocks, bonds play an important role in this approach.
Bonds also help mitigate what’s known as “sequence of returns risk”: the risk that your portfolio suffers a market loss at an inopportune time, like the start of retirement.
As a Source of Stability During Challenging Market Conditions
Research shows that while short-term market fluctuations are inevitable, investing in the stock market is the recipe for success when it comes to long-term growth. However, in addition to helping achieve some of the goals mentioned above, it’s also important to factor in the emotional protection that bonds provide. To paraphrase Andrew Denenberg’s recent article, market fluctuations should ultimately have no impact on your quality of life; if they do, your asset allocation likely needs an adjustment.
Financial markets can be volatile, and it can be tempting to check a portfolio on a daily basis. Those who do check their portfolios frequently when the market is in turmoil are often reassured to see the bond portion of their portfolio holding relatively steady, which helps reduce stress during chaotic times.
As advisors, we often see that people overestimate their risk tolerance when the market is performing well. That makes sense; if markets are moving higher, it’s natural to want to be part of the move. But people also tend to have short memories when it comes to investing, which causes them to mentally downplay just how bad they felt when things were at their worst.
While everyone remembers the COVID market drop, some people may have forgotten the panic they felt when the market was nearing its bottom. It’s perfectly okay to sacrifice a little upside in exchange for the downside protection that comes with having a sensible allocation to bonds.
Bonds help a portfolio keep its value during tough times, and if the protection they provide helps you sleep better at night, they’re well worth the investment.
As a Rebalancing Tool
“Dry powder” is an industry term that refers to a portfolio with highly liquid assets — like bonds — that are intentionally kept separate from the stock market. And as the past few months demonstrated, bonds can be a particularly effective source of dry powder when the market declines.
When stocks sank in March, many of our clients suddenly found themselves below their target equity allocations. This is because bonds held their weight in a portfolio relative to the drastic decline in stocks. Fortunately, we were able to easily sell some bonds and use the proceeds to purchase more stock at depressed valuations, effectively putting the dry powder into the market. And when the stock market began to recover, those extra stock purchases helped portfolios bounce back faster. Combined with tax-loss harvesting, this can significantly add to the after-tax return of your portfolio.
To be clear, I’m not recommending an all-bond portfolio, nor am I here to tell you that you need an all-stock portfolio; as the old saying goes, “everything in moderation.”
What I am here to tell you is that it’s prudent to work with a trusted advisor who understands your risk tolerance, your financial situation, and your goals — especially your long-term financial vision. If you have any questions about your portfolio or your ideal asset allocation, we can help. Reach out to your advisor at Strategic Wealth Partners to discuss your options.