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Why own bonds?

Yesterday we talked about a poor reason to own bonds. Today I want to discuss a valid reason. Adding a bond component to a portfolio of stocks (or stock-based funds) serves one primary purpose: It reduces volatility.

Still in the buying stage?

If you’re young–or more specifically, if you’re dollar-cost-averaging into your investments–volatility actually increases your return. So it’s hard to classify it as entirely undesirable.

That said, as we’ve seen in the last year, the volatility that comes with a 100% stock portfolio can be downright terrifying for some people. If you think that a high degree of volatility is likely to either:

  1. Cause emotional/psychological problems (trouble sleeping for instance), or
  2. Cause you to panic and sell after a downturn

…then it’s probably a good idea to include a degree of fixed income when determining your asset allocation.

To put it differently: The bond component isn’t there to protect you from volatility per se. It’s there to protect you from yourself.

Planning on selling soon?

On the other hand, if you’re at the point in your life where you’re dollar-cost-averaging out of your investments, then volatility has the opposite effect: It decreases your returns.

Note the difference here. When you’re buying, volatility is a mixed bag–it has both positives and negatives. When you’re selling, however, volatility has no redeeming qualities at all. In short, that’s why it makes sense for investors to shift their asset allocation more toward fixed income as they get closer to retirement.

It’s all about balancing.

Regardless of which stage you’re in, including bonds in your portfolio involves a trade off. You’re exchanging expected returns for reduced volatility.

  • If you’re still buying, the purpose of reducing the volatility is to provide you with the psychological benefits mentioned above–to protect you from yourself.
  • If you’re selling (or will be in less than a decade or so), reducing volatility increases your expected returns as well as providing all the same psychological benefits.

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Comments

  1. Surely there are reasons to avoid risk other than psychological failings. At some point a calm and rational person would want to avoid adding volatility to their portfolio, wouldn’t they? Put another way, why stop at 100% stocks? Why not buy on margin to get 200%? Or use options or levered ETFs to go even further?

  2. Hi Frank.

    I didn’t mean to imply any psychological “failings” as such. For instance the “having-trouble-sleeping” scenario that I brought up is fairly normal in my opinion and can be experienced by somebody who is both “calm and rational” (or at least as calm and rational as any of us are).

    Regardless, I do think that the difference between a 25-year old who is 80% in stocks vs 100% or 120% in stocks is a psychological one. (And I could see any of those 3 positions as being reasonable for various people who I’d include in the category of “calm and rational.”)

  3. Thanks for the informative post. I’m not worried much about my funds, but I still like to consider other options now and again.

  4. The final paragraph above “It’s all about balancing” is so neatly succinct. Is your book 10 pages long (but full of value!). I mean this as a compliment, in case that’s not clear! ๐Ÿ™‚

  5. Hi Monevator. Thanks for the compliment. The book is (a little) more than 10 pages long. ๐Ÿ™‚

  6. LostInMidlands says:

    I agree with Monevator: it’s a very succinct and well-justified post/opinion. Your arguments would be easier to appreciate and apply, though, if you made an effort to quantify the trade-off between returns and volatility. Merriman (FundAdvice.com) provide a rather neat table that summarizes the trade-off in a very readable format:

    http://www.fundadvice.com/articles/buy-hold/fine-tuning-your-asset-allocation.html

    http://www.fundadvice.com/images/stories/fundadvice_images/fine_tuning_2008.pdf

    You can derive from there, e.g., that in the (long enough to be indicative) period from 1970 to 2008, the 70% equity/30% bonds portfolio had only 10% smaller annualized return than the 100% equities portfolio (10.6% vs 11.8%), while reducing the (standard deviation measure of) volatility by 30% (10.4% vs 14.6%).

  7. Hi LostInMidlands.

    Thanks for sharing that chart. Pretty neat compilation of data there. ๐Ÿ™‚

    A few thoughts on it:

    I’m reluctant to describe something as having “only 10% smaller annualized return” for the reason that I suspect some readers might come to the conclusion that the 10% decrease in return means a 10% smaller ending value. In reality, that 10% decrease in return means an ending value of only 2/3 the ending value provided by an all-equity portfolio–if we assume a lump-sum invested at the beginning.

    Also, (for better or worse) I actually tend to go out of my way to avoid quoting data to explain a point. Whenever possible, I’d rather try to explain the reason behind why something happened rather than quoting some figures and saying “here’s what happened.”

    In my opinion, an understanding of the concepts behind investing is more useful than historical performance data, which can tempt us into believing we can predict things more precisely than we can.

    That said, that chart is great–showing year by year returns rather than simply “here’s how portfolio X did over the entire period.”

  8. LostInMidlands says:

    Mike,

    thanks for your response: it is a very sensible and ambitious, if perhaps not always optimal, policy to avoid quantifying (past) investment returns, and to focus on explaining the mechanisms and concepts, rather than mining historical data.

    I’m quite sure you will agree, however, that before a “story”, mechanism, or concept is suggested/accepted as good practice in investment (e.g., your claim that the more stocks you own in your portfolio the better return you can expect in the long run), we must make serious attempts to “falsify” it (or, stress-test it, lol) by rigorous and robust back-testing. (Note the focus on “falsification” rather than “validation”. Good past performance does not imply that an idea “works”, but consistently bad past performance is strong evidence that it doesn’t.)

    Since neither the Merriman data nor the article seem to mention regular rebalancing, my question to you is: do you know what relative performance of the 11 Merriman portfolios (the 11th being the one that you’re promoting: 100% equities) has been (over long periods), given that, say, the portfolio is rebalanced at every year-end?

    And what about a more realistic scenario in which an investor is not dumping a lump sum and holding the same portfolio forever, but is instead dollar-cost averaging for a typical 40-year working-life period and rebalancing once every year?

  9. You’re absolutely right: data is useful for the purpose showing that a strategy does not *always* work. (I just posted about this on Monday in fact.)

    Also, I fully agree that a lump sum invested for 39 years isn’t exactly a common real-life scenario. My only point was simply that a seemingly small decrease in return can lead to a surprisingly large decrease in accumulated wealth.

    To be clear (as I mentioned above in my comment to Frank), I’m not “promoting” a 100% equity portfolio. I’m just arguing that the primary benefit of reducing the equity allocation (if you still have at least a few decades until retirement) is a psychological one–not that that means it isn’t a real benefit. Clearly, mental comfort has a very real value.

    As to your question about rebalancing, I intend to address that in an upcoming post in the near future. The main idea being that one of the points in favor of holding multiple asset classes in a portfolio is that–if rebalanced regularly–the annual return for the portfolio tends to be greater than the weighted-average return of the various asset classes.

  10. By the way, thanks for taking the time to contribute your thoughts.

    One of the most fun parts of writing this blog is that–for whatever reason–it seems to have attracted a group of readers most of whom appear to be particularly well informed and insightful.

    Makes for a some great discussions. ๐Ÿ™‚ Much better than the typical “Hey, awesome post!” fare that you see on many other blogs.

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