Rethinking the Stock Bond Ratio


The rule-of-thumb is to “put your age in bonds,” meaning that the percentage of your portfolio placed in bonds should be equal to your age, with the remainder placed in stocks.  For example, a 20 year-old should have 20% bonds and 80% stocks.  A 60 year-old should have 60% bonds and 40% stocks.

The idea is that when you are young and don’t need the income from investments, you can have your money mainly in stocks which will have greater return than bonds, but with a lot less predictability and bigger fluctuations in price.  As you get closer to needing to draw income from your investment, you reduce the volatility – the size of the fluctuations in the price of your assets – of your portfolio by purchasing more bonds, which tend to be more stable and predictable.

Ideally, when you are actually using the income from investments for day-to-day expenses, the bonds you own will be paying enough income that you will never need to sell any of your assets for cash.  The bonds will just put interest payments in your account as you need it, allowing you to leave the principle alone.  As time passes you will sell more and more of your stocks, buying bonds with the proceeds, eventually ending up with 100% bonds when you are 100 years old.

Understand that by “bonds,” what is really meant is income-producing assets.  Things that pay a certain amount of money to you as the owner on a regular basis.  True bonds are loans made to companies or municipalities for which interest payments are paid, typically on a 6 month basis.  Eventually the loan is repaid as a lump sum when the bond matures, leaving the investor to buy another bond and start the process again.  Other income producing assets include stocks with large dividends, real estate (or real estate investment trusts), and assets such as limited partnerships (warning, the taxes here get complex).

Because these types of assets pay a predictable interest or dividend payment, and because, in the case of true bonds the investor is repaid the principle when the bond matures, they are considered less risky than stocks.  Even when the price of the assets decline, the investor is at least getting the interest payment.  This is not to say they are totally safe.  I have seen many companies go bankrupt and pay pennies on the dollars for their bonds.  I’ve also seen many companies cut their dividends severely, causing their stock price to fall.  This is why you don’t just buy bonds in one company or one piece of real estate.  You buy a several different bonds or a bond mutual fund.  You buy several properties or even several different Real Estate Investment Trusts (REITs), or a mutual fund that buys REITs.

One issue with this strategy is that people are living and working longer.  People used to retire when they were 65 and die when they were about 70 or 75.  Now they are retiring at 70 or later and living to be 85 or 90.  You may need a larger return on your money to make it last through your retirement, and you may not need to draw your money when you are only 65 because you still have an income from a career.  Some planners have suggested investing your age minus ten, such that you would be 55% in stocks when you are 65 instead of 65%.

Another question to ask is whether the stock/bond ratio is right when you are younger.  Over long periods of time, a diversified portfolio of stocks will always outperform one of bonds.  Stock returns before inflation average 10-15%, while those for bonds average 5-8%.  Why should you invest some of your money at 5% when you can get 10%?

The only issue with buying all stocks is that the return will be unpredictable – up 25% some years and down 15% others.  You could see your $10,000 portfolio cut to $5,000 over a year or two, but then see it soar up to $40,000 when the market takes off and has a couple of good years in a row.  You never know when the big moves that cause the return to average out to 10-15% will come.  If you are 25 and won’t touch the money for 40 years, however, it should not really matter.  This is provided you have the intestinal fortitude to tolerate the gyrations (or are able to just put your account statements in a drawer and not look at them).

The question then is when to start buying income securities (bonds) and lightening up on equities (stocks).  Really, there are very few times where the stock market has been down after a five-year period, and almost no times when the market has been down over a ten-year period.  This means that starting to shift from an all equities portfolio into an income and equity portfolio when you  are 10-15 years from needing the money would be fairly conservative.

Another factor, however, is the market conditions.  In the early 1980’s, many high quality bonds were paying 20% or more.  This is because inflation was so rampant that investors were demanding high returns before they would lend their money, and because the Federal Reserve was raising government bond rates to 18% or more to try to quell that inflation.  The return on bonds was higher than the long-term return on stocks, so it would make sense to buy more heavily into bonds at that time.  Why look for a risky 15% return when you can get an almost guaranteed 20% return?

Another factor is the performance of your portfolio at the time.  If you are currently heavily invested in equities, you’ve had a great year with the large caps up more than 25% and the small caps returning about 40%.  It would make some sense to preserve some of those gains and perhaps shift into some dividend paying stocks if you are 15-20 years from needing the money.  Those stocks would hold up better than pure growth stocks should the economy falter, perhaps allowing you to buy back into growth stocks at a lower price later.  Bonds would be a poor choice currently just because the rates are ridiculously low, again because of the actions of the Federal Reserve.  Moving some stock positions into paid-for real estate or REITs is another option.

A final factor is the size of your portfolio relative to your income needs.  If you need $30,000 a year for living expenses, this could be provided easily with a $1 million portfolio.  If you only had $1 million, you would need to be very careful since a decline in its value would result in a decline in your income and/or increase the risk that you will outlive your money.  In this case, purchase of an annuity might even be in order to guarantee an income level.

If you had a $10 million portfolio, however, you could take a substantial decrease in the value of the portfolio and still have plenty of income for expenses.  In this case you might treat a portion of the portfolio, $1 million say, as an income portfolio and leave the rest to grow in equities.  During the good years in equities you could take some of the gains, increase the income portion such that you could draw more each year, and buy extra luxuries such as trips and home improvements.  During the bad years you could just draw the income from the income portion of the portfolio and leave the equity portion to recover.

The idea of shifting to income producing assets as you near retirement has merit, but “owning your age in bonds” may not be the best strategy.  The best idea is to build a portfolio large enough that you can generate plenty of income for critical expenses with a small portion, leaving the rest to grow in equities and provide supplemental income.

Contact me at vtsioriginal@yahoo.com, or leave a comment.

Disclaimer: This blog is not meant to give financial planning advice, it gives information on a specific investment strategy and picking stocks. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.

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