How much of your retirement portfolio belongs in bonds?
Reprinted courtesy of MarketWatch.com
Published: June 17, 2015
To read the original article click here
Bonds aren’t particularly sexy investments, and many people shun them because of the fear of rising interest rates.
I explored this in a recent article: “Why bonds are the most important asset class.”
To recap, equities are like the engine in a car. They provide the power to get you where you need to go. Similarly, bonds are like brakes; they should keep you safe when the equities get rambunctious.
The crucial question, which I’ll address here, is how much of your portfolio should be in bonds and how much in equities.
It’s a classic trade off. If you overdo the equities, you have higher long-term expected returns, but you’re risking higher volatility and losses. If you overdo the bonds, you’ll have much less volatility and risk, but you’re risking returns that are too low.
To help you figure out the right combination for you, I’m going to show you two tables of numbers that have been helpful to thousands of investors facing that question.
But first, since this is a discussion about the intersection of return and risk, let me pose a question: Which of the following is your goal?
- Do you want the highest return you can get within your risk tolerance?
- Or do you want the lowest-risk way to meet your financial needs?
While you ponder that, let me introduce you to our fine-tuning table. Each column in the top part of the table shows year-by-year returns for 11 combinations of diversified equities and bonds, from 100% bonds to 100% stocks. A 12th column shows that year’s return of the Standard & Poor’s 500 Index SPX, +1.49%, for reference.
Why should you care about all these numbers? Because they give you a realistic look at what it would have been like, from 1970 through 2014, to own various combinations of equities and bonds.
For example, if your portfolio were 100% invested in diversified equities, you can see by scanning down that column that there were a few pretty bad years. The worst by far was 2008, with a loss of 41.7%. Not many investors could easily keep their calm through that storm.
The years 1973, 1974 and 1990 also had double-digit losses in the all-equity portfolio.
However, the payoff for long-term investors who could stay the course was a 45-year compound return of 11.8%.
For one other example, look down the 50/50 column, and you’ll see that having half your portfolio in bond funds reduced the losses significantly: The only double-digit loss was in 2008.
The bottom part of this table attempts to quantify the risks of each equity/bond combination by showing the worst returns for various periods: three months, six months, 12 months, etc.
How can you apply these numbers to your own portfolio?
To get the most from this table, you should know two things. The first is how much risk or loss you think you can accept and still remain “in the game” without selling or losing sleep. The second is what long-term return you require to meet your needs or goals.
How you determine those figures is beyond the scope of this article. But once you know them, you can return to the question I posed above:
- Do you want the highest return you can get within your risk tolerance?
- Or do you want the lowest-risk way to meet your financial needs?
If you want the highest return within your risk tolerance, look at the bottom part of the table and imagine sustaining the losses in each column. Pick a column with losses you believe you’ll be able to tolerate.
In order to get your expected return, you will need to be willing and able to stay the course without knowing when (or whether, for that matter) you will recoup your losses.
I think this table is relatively representative of the losses investors are likely to face in the future. The 45-year period shown here included three severe bear markets and a one-day crash in 1987 in which the U.S. stock market lost 22% in a single session.
On the other hand, if your goal is to meet your financial needs in the lowest-risk fashion, I think you should use a financial adviser to review your need for return. If you aim too low, you may come up short when it’s time to retire. If you aim too high, you’ll need to take on unnecessary risk.
I also think you should assume that the returns you will get will be less than those shown in this table. I suggest you subtract two percentage points from the long-term return in each allocation.
For example, the table shows a compound return of about 8% for an allocation of only 30% in stocks. If you subtract two percentage points from each of the compound returns, you’ll see you should have about 70% in stocks to achieve a similar return.
If there’s too much risk in that combination, then you can reduce your needs by planning to save more money each year or postpone retirement for a year or two. Those are much better alternatives than taking too much risk.
My suggestion is definitely conservative, assuming lower returns in the future. But being in this business for half a century has taught me the value of being conservative. I have never met any retiree who regretted saving too much money. But I have met many who regretted taking too much risk.
I have spent years studying this table, which I update annually. For readers who like numbers, here are a few things I’ve learned:
- Adding 10 percentage points of equities (and subtracting 10 points of bonds) adds about 0.55% to the long-term return.
- Each additional 10 percentage points of equities increases a portfolio’s volatility by 10% to 20%.
- Each additional 10 percentage points of stock exposure increases losses by 4% to 6%.
Finally, a few notes about this particular 45-year period of market history.
This was a tough period for bonds, including sharp increases and prolonged, deep decreases in interest rates. In the early 1980s, interest rates were so high that banks were offering 16.5% on 2.5-year certificates of deposit. Many conservative investors thought they would never need to own stocks again. Wrong!
During this period, investors in the 100% diversified equity portfolio experienced 15 consecutive years (1975-1989) of positive returns and a 25-year period (1975-1999) with only one losing calendar year (1990).
This was truly a “golden age” for equity investors, and many baby boomers who put money aside for retirement can be thankful for their timing.
Yet those who began saving just 15 years ago weren’t so lucky. Since the turn of the century, the S&P 500 has suffered four annual losses, including three in a row (2000 through 2002) and another stunning loss in 2008.
How you would have experienced the past 45 years depended to a large extent on when you started investing.
Results that might look like the result of great skill or wisdom (or lack of them) may in fact be in large part due to good or bad luck.
This is always true: We cannot know in advance the best time to invest our money nor the best time to withdraw our money. The best guidance I can give is to invest money when it’s available and withdraw it when you need it.
If you keep your expectations reasonable and invest conservatively, the probabilities of success will be on your side.
To learn more about using these stock/bond combinations, check out my podcast on this topic.
Richard Buck contributed to this article.
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