Where Do Bonds Fit in Your Investment Plan?

March 20, 2014 -- Conventional financial wisdom holds that bonds are an essential part of any portfolio. But while bonds can play an important role of adding security, whether to include them – and if so, at what level – isn’t an automatic decision.

Current economic conditions don’t favor making many types of bond investments. But even for the long term – in good economies and bad – determining asset allocation to bonds is a complex undertaking that varies with the individual. You should start by asking a critical question that should apply to every component of your portfolio: What role do you expect bonds to play and why? To answer that question, you must understand the risks, advantages and dynamics of bonds and the different types of bonds and bond products accessible by most investors.

The right bond investments can play the important role of capital preservation and risk management for investors, including many women who, as a gender, tend to have a lower risk tolerance than men. This tendency has served women well because, studies show, they tend to make fewer investing errors than men.

Yet, the notion that all women or men should necessarily have a substantial part of their portfolios in bonds stems from the myth of the average investor — a plain-vanilla, typical investor. In my practice, I’ve never met that investor. Each investor is different, so it doesn’t make sense to average their characteristics together and come up with a one-size-fits-all recommendation that actually applies to few people.

For example, I have a middle-age client who chooses not to own bonds and instead owns an otherwise diversified portfolio that includes stocks and alternative investments (natural resources, real estate and international stocks). I support his decision because this suits his situation. He can do without bonds because his substantial “bond-like” income is secure and he has ample cash reserves to protect him from damage due to severe dips in the stock market. He also has a high risk tolerance. I wouldn’t recommend a bondless portfolio to people with shorter time horizons, insecure income, lower cash reserves or a lower risk tolerance.

Many people believe that as soon as they turn 65, they must cash in stocks and convert their entire portfolios to bonds to eliminate risk because of fears that the stock market will crash. Ironically, in doing this they’re creating longevity risk – the risk that their resources won’t keep pace with expenses over the next 20 or 30 years. So, in focusing too much on bonds, they trade one risk for another.

They make this mistake because advisors have traditionally recommended an increasing percentage of bonds in portfolios as investors age. This recommendation is based, in part, on the widespread belief that bond prices aren’t correlated with stock prices — that their prices move in opposite directions. But this isn’t necessarily the case with corporate bonds, whose prices move in the same direction as these companies’ stocks far more often than is generally understood.

Numerous studies point out periods when stocks and bonds have indeed been correlated, and you don’t need a Ph.D. in finance to know that this happened in 2008 with corporate bonds. If you had investments in stocks and corporate bonds then, you still remember the pain from declines in both. (However, government bonds and international bonds did well in 2008, providing portfolio relief to those who owned them.)