Why hold bonds? I mean I defer to many here that believe that a small portion of bonds is a better investment but I just am having trouble seeing the logic. That said, this is largely because I invested after the crash and so have only really been seeing massive stock market gains and low interest rates, I imagine those will end. Right now I have about 80% stocks/20% bonds. Looking to be able to retire in under 10 years though there are other factors at play.
It's true that if you just put 80% of your money in a stock index, and 20% in a bond index, and leave them alone, it will do worse than 100% stocks in the long term. The magic is in the rebalancing.
Here's a simplistic analysis: suppose the stock market crashes by 50% and then recovers, but the bond market is stable. (I know, I know.) Suppose also that you're investing $1600 in:
A) 100% stocks. Your investment just tanked, it's now worth only $800! Fortunately you're still in the accumulation phase, so you don't sell any of those stocks for peanuts. Soon enough your investment grows back to $1600.
B) 75% stocks, 25% bonds. Your stocks just tanked, they were $1200 but now they're $600! Fortunately, you're still in the accumulation phase, so you don't sell any of those stocks for peanuts.
But wait, it's time to rebalance; you have $400 in bonds, so you currently hold 60% stocks, 40% bonds. To maintain your asset allocation, you need to sell $150 of your bonds and buy $150 more in stocks. Your holdings are now $750 in stocks and $250 in bonds, perfect!
Now when the stock market recovers, your $750 doubles to $1500, and your holdings will be $1750 - you made an extra $150. That's over 9%, over a recession when stocks made 0% and bonds made 0% - with no supernatural market-timing powers - magic!
(If you had supernatural powers, of course, then you could have made 100%. But you don't.)
By rebalancing, you sold bonds when they were relatively high, and bought stocks when they were relatively low - buy low, sell high, like you heard in the movies.
- When stocks fall more than bonds, as in this scenario, you make more than the guy with 100% stocks.
- Something similar happens when bonds fall more than stocks (unusual, I know, but you profit here too).
- If bonds rise more than stocks (not that unusual, it happened for a recent decade), then that's growth the 100% stock investor won't see, too.
- The missing case is when stocks grow more than bonds, which admittedly is very common. In this case, you'll see a little lower return than the 100% stock investor. (You can't have your cake and eat it too.)
But making a bit of a loss in scenario 4, in exchange for profit in the other three scenarios - and lower volatility overall - could be a very good tradeoff, even for investments as long-term as 30-50 years. And you could hold 80%/20%, or 90%/10%, to make less off of market crashes, but perform better in the boom years, if it suited you.