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When building your investment portfolio, one of the first things you must figure out is how much to allocate towards stocks and bonds. The rule of thumb I often hear is to subtract your age from 110, and that should be the percentage of your portfolio allocated towards stocks, with the rest going towards bonds. This advice, while not horrible, is not efficient in many scenarios. It is much better to consider your complete financial picture and make decisions based on the return of your overall net worth and not a single investment account.
For many people, I would argue that it doesn’t make sense to own bonds at all. For others, bonds can be a great asset class that should be included in their investment portfolio. And no, I am not just referring to someones age. By simply allocating funds efficiently, you can have a far greater return on building wealth than the “rule of thumb” above, and without adding any risk your portfolio.
When Money Allocated Towards Bonds Could be Better Utilized
Have consumer debt – If you have consumer debt, there is a high likelihood that the interest rate is much greater than current bond yields. It makes very little sense to own bonds when you have consumer debt costing you with interest rates in excess of 10%. I really like Financial Samurai’s guide in how to allocate your savings for debt pay down and investing. I would put the caveat on his advise that the allocations should go towards higher yield investments like stocks. It does not make sense to invest in bonds with a non-guaranteed rate of return when you can get a fixed return by simply paying off debt. It is important to look at the return of your overall net worth and not a single investment account.
Have a home mortgage – Under the new GOP tax plan, it will make more sense for many home owners to use the standard deduction; therefore, essentially eliminating the tax benefit of paying mortgage interest. Previously, it could have been argued that mortgage interest payments are “cheaper” than the sticker price due to the tax benefit. With it now essentially being a wash, it may make a lot more sense to simply pay off your home mortgage faster. If you are investing for return on net worth, any money that would have been allocated towards bonds should be put towards paying down a mortgage. Some may argue that your home is not an asset, and whether you believe this or not, a mortgage is certainly a liability.
Have a long time until retirement – I am a big fan of passive investing in low cost index funds. If you want to maximize growth and have the stomach to ride market volatility, investing 100% in stocks will likely outperform a diversified portfolio over the long run. If you don’t need to live off investment returns for 10+ years, than I would not argue that it’s a bad idea to invest 100% in stocks. As long as you are aware of the inherent risks of investing in the market, then by all means, invest for growth.
When It Makes Sense to Own Bonds
Within 10-15 years of retirement – If you are nearing retirement or are more interested in wealth preservation than wealth accumulation, then bonds can be an excellent asset class to own. Bonds typically show low correlation with stocks and can therefore reduce portfolio volatility and risk. By owning bonds you are likely giving up potential returns, but it is not a bad idea to mitigate some risk. This is especially true if you need to live off your investments and can’t afford to ride the market swings.
Have no debt – If you have debt, than paying off debt is essentially a return equal to the interest rate. If you don’t have debt, than you may want to own some bonds to reduce the volatility of your portfolio. Anyone investing in the market has to be comfortable with their risk tolerance. If you lose sleep at night due to scares in the stock market, please, sell some of that stock and buy some bonds.
Saving for a purchase in the immediate future (2-5 years) – If you are saving for a large purchase and don’t want to leave your money in a low yield savings account, than investing in bonds could be a viable option. You are likely not going to make much meaningful return on your investment in only 2-5 years; however, it will likely be greater than nothing. Psychologically, I hate having money sit in cash, knowing that it is just losing purchasing power over time due to inflation.
What is the Appropriate Bond Allocation?
If you decided that you should include bonds in your investment portfolio, then the natural next question is how much? Well, the “rule of thumb” as mentioned above could be a good place to start. In reality, it’s all about your risk tolerance and investment timeline. If you are very aggressive, you may elect to own more stocks than the rule of thumb may suggest. By all means, if you have the stomach for it, you will likely be rewarded for taking the added risk.
I will say this, many of us say we have a high risk tolerance because we want to maximize growth. I think many people have found this not to be true when the market takes a big hit. You must be able to ride the market swings because it is nearly impossible to correctly time the market. For those who try, they may have gotten it right a couple times, but most tend to lose big over time. The market is not intuitive, and making emotional decisions can be very costly.
Many of us don’t know our true risk tolerance until we take an investment loss. It is much better to simply own a larger portion of bonds, sleep better at night, and avoid the potential catastrophic mistake of trying to time the market.
Disclaimer: I am not a financial professional and no information on this site is not intended to be investment advice. Posts on this site are intended to challenge our thinking to make smarter financial and investing decisions.