I know that I'm supposed to have a portion of my portfolio in bonds…but what I don't understand is why I would buy bonds right now. Here's what I have gleaned:
- Bond income is generated in the form of interest. Interest rates are currently at historic lows.
- When interest rates are low, bond prices are high. In general, you don't want to "buy high."
So…I don't get it. What am I missing? Why am I supposed to buy these things? They seem like a bad deal, but if the entire industry says to buy bonds I know I must be misunderstanding!
There are two main reasons to own bonds.
1. Income: If you are retired you probably care about income. If you are still accumulating you probably don't which brings us to...
2. Lowering your risk. A 100% stock portfolio can average 10% growth over longs periods of time, but you can encounter drops of 40-50%. On the other hand a portfolio that is 60% stocks and 40% bonds can average 7-8% growth over long periods of time, but you can encounter drops of 25-30%. Getting 2% more average growth means adding a tremendous amount of volatility.
Now I'm actually the person who isn't going to tell you to buy bonds. If you don't need income, and you are ok with taking on a lot more volatility to get a little more return than you might not need bonds. I am 20/80 or 60/40 in my accounts where I might need the money in 1-5 years, but in my long retirement accounts I'm 100% stock. I'm ok with the volatility. Whether you are ok with that level of volatility is a question you need to really reflect on. If the news was reporting "crisis, ahhhhh, run around like a chicken with its head cut off, stock brokers are jumping out windows, ahhh!!!, the dow is down a bajillion points, ahhh!!!!" can you look at your portfolio down 40% and still keep a cool head?
If you want the most complete explanation, read "The Intelligent Asset Allocator" by Bernstein. It's not really math-heavy, but it's beyond most people who have not taken statistics or don't have a decent understanding of math.
If you want what he calls "the liberal arts major" explanation, read "The Four Pillars of Investing," by Bernstein.
The bonds are not there to give you a long-term return. They're there for diversification, to even out your ride. And they're not necessarily there just so you don't panic and sell out at the bottom. They provide the valuable function of capital preservation in a long-term buy-and-hold strategy.
You can use bonds in a portfolio aggressively. Slide your stock/bond mix to 70/30 or 60/40 right now. Yes, your performance will drag, but you'll still have capital appreciation and mostly participate in the bull market. The current bull market is getting long in the tooth. Who knows how long it will continue, but it won't last forever. When it eventually crashes, you have a significant proportion of reserves in that bond fund that didn't drop with everything else. You can then reduce your stock/bond mix to 80/20 (lowest Bogle recommends) or 100/0 (where many people seem to be now).
With that strategy, you're maximizing your stock buying after a market crash. That's also called "buying low."
As for an indicator of how frothy things are getting, look at the number of people advocating going 100% stock, like it isn't risky. Increased speculation is a contrarian indicator. Eventually, there will be a correction. Bonds will preserve some of your portfolio so you're not falling behind.
Now, this sliding strategy is very aggressive. A more rational approach is to select a stock/bond mix and stick with it. The normal portfolio diversification approach reduces losses, so you don't have to recover so much ground.
If you want to see this in action, go to Vanguard's fund performance comparison, and compare VTSAX (US Total Stock Market), VGTSX (International Total Stock Market), and VFIUX (Intermediate-term US Treasuries). Compare hypothetical growth of $10,000 over 10 years. Obviously, the two stock indexes initially outperform treasuries until a market peak in 07 (VTSAX $13,723; VGTSX $17,613; VFIUX $11,282). The market slides throughout 2008 and crashes, reaching a bottom in early 2009 (VTSAX $7,309; VGTSX $6,795; VFIUX $12,896). Treasuries stay ahead until 2013, when VTSAX finally recovers enough to overcome its losses. VFIUX doesn't get ahead of Treasuries until 2014. In other words, boring, low-interest rate treasuries actually were beating the two stock indexes for about half of the last ten year time period. And that's assuming 3 separate $10,000 investments.
If you combine all three portfolios, sometimes International stock outperforms, sometimes US stock outperforms, and sometimes Treasuries outperform. When the market tanks, funds are rebalanced from the treasuries to the stock side of the portfolio and the overall portfolio will outperform a non-diversified portfolio over the long term.
But what if you simply bought VTSAX and held it by itself? Doesn't that beat all the others? Yes, it beats the others in hindsight. But you can't predict which of these three will be the best choice 10 years from now. Even VTSAX lagged the other two funds for 8 out of the last 10 years.
The balanced portfolio with US, International, and highest quality bonds outperforms a non-diversified portfolio over the long term. Any one of the component assets will outperform the diversified portfolio at any given time, but you can't predict in advance which one.
Right now, many people want to hold VTSAX only, because International Total Stock Market performance stinks. Yes, it does, for the moment. But will Asia be in recession forever? Will Europe always be in crisis? Is it reasonable to project that the rest of the world economy will just collapse and never recover? The reason buying an asset low is so hard is that that's when nobody wants it. If everybody wanted it, the price wouldn't be low.
I think the saying is that if you don't like one of the assets in your diversified portfolio, you're not doing it right.
Sorry I'm only referring to a chart and describing it rather than inserting one. I haven't figured that out yet.