Bonds and income stocks are an important part of a portfolio. While bonds won’t provide the returns that stocks will over long periods of time, when there are falls and crashes in the stock market like in 2008, bonds will usually hold up in price while stocks will fall. Indeed, in 2008, those who were 50% in bonds, say, might only have seen their portfolio’s decline by 5% or 10%, while those 100% in stocks were looking at 40% drops. Some bond holders even made money while everyone else was seeing their portfolios decimated.
A rule of thumb is that you should invest a percentage of your portfolio equal to your age in bonds. If you are 20, you should be 20% in bonds and 80% in stocks. If you are 80, you should be 80% in bonds and 20% in stocks. If you are 100, you should be thankful you’re alive and be 100% invested in bonds. If you’re 110, I guess you need to short 10% of your portfolio and invest the proceeds in bonds or something. This is the conventional wisdom and we should never doubt the wisdom, right?
Except I do. I am in my 40’s, so I should be 40% in bonds, but instead I’m 100% in equities. (OK, maybe 97% in equities and maybe 3% in cash.) I plan to be the same way when I’m in my 50’s, and I hope that I can be the same way when I’m in my 60’s and 70’s, although I may diversify into real estate at some point by buying some vacation homes, just for the fun of it.
I know that buying bonds (and income producing stocks) reduces risk, and I know that the additional reward that I can get for being 100% in stocks is just a little better than it is for being 70% in stocks and 30% in bonds, say. But that’s just it. By putting money into bonds that could be in stocks, I’m giving up a few percentage points of return that I could be getting from a 100% equity portfolio. I know that over a long period of time, like 20 years, the difference between making a 12% return or a 15% return and a 10% return is huge. You see, at a 15% return, by portfolio value will double every 4.6 years, while at 10% it will double every 7.1 years. In 20 years, 100,000 will be worth about $400,000. At a 15% return, the same $100,000 will be worth more than $800,000.
Now what is the consequence of not owning bonds? Well, in years like 2000 and 2008, I’ll see a big drop in portfolio value compared to a portfolio with more bonds. A portfolio with about 70% bonds and 30% stocks will be lowest risk of all, meaning swings in portfolio value will be substantially less than a portfolio that is 100% stocks or even 100% bonds. During years like 2008, people who had 60% bond/40% stock portfolios may have even seen an increase in their portfolio values while those with 100% stock portfolios saw 40% declines. During the next year, however, the 100% stock portfolio saw a 30-40% increase, and another 20-30% increase the year after that. You risk having big drops in the value of your portfolio, but you’ll also see recovery if you can just stick it out or, better yet, invest more while prices are low.
Having a 100% stock portfolio when you are a few years away from retirement can definitely be a bad idea. Certainly there are a lot of people who were ready to retire in 2007 after seeing the value of their 401k’s increase from 2003-2007, only to see their plans of spending time on the beach put on hold after suffering substantial losses in 2008. In 2008 they were still heavily invested in stocks, hoping to get one more great year to feather their retirement nest. Instead they saw a bear market for the record books.
Many advisers propose being very conservative going into retirement, having maybe a 60% bond and 40% stock portfolio, and then actually getting more aggressive as time passes. There are studies that show starting very conservative right when you retire but then being more aggressive later in retirement increase your chances of outliving your money. The idea is that when you are just starting out in retirement, a big loss would be devastating, but it becomes less significant as you get older and no longer looking at as many years of life. Someone who is 70 might be 70% stocks and 30% bonds again.
Despite the risk of suffering a big setback, I would still like to be mainly invested in stocks even going into retirement, however. I know that I’ll enjoy much better returns in equities, and therefore have more cash flow to enjoy life, if I’m in stocks instead of being heavily in bonds. Even at age 65, I still have about 20 years to invest and I know that for periods of 10 years or longer, I’ll have returns on the order of 12% in stocks before inflation.
Staying fully invested in stocks is not an option, however, if you have just enough money for retirement, which today is somewhere in the $1M to $3M range. In that case, if you had a large, 50% portfolio loss, you would run the risk of running out of money, This is because, after a large drop, you’ll need to take more money out of your portfolio for expenses than it can withstand. Once you reduce the balance of the portfolio enough that it no longer produces enough to regenerate itself for the amount you extract, it becomes a vicious cycle. Each time you take more out, you reduce the amount of income it can generate. Next thing you know, you’re moving in with your kids.
I’m hoping (and planning) to have more that I need for expenses, however. If I have a $6 M portfolio, I can set aside a relatively small portion in bonds (or even just put five years’ worth of expenses in cash) and keep the rest invested in stocks. If the market takes a tumble, I can just wait for it to rebound since I’ll have expenses covered. When the market does well, I can sell some shares and build up my cash position. When it does poorly, I can sit pat and use the cash I have.
The other advantage of building up a bigger portfolio than the bare minimum is that I can stay mostly fully invested even as I approach retirement. When you are just starting to invest, the return on my account was relatively small (maybe a few hundred dollars a year. When I get to the point where I have a few million dollars in my account, however, I would be making a million dollars or even two million dollars during years where the market goes up 20 or 30%. Most people miss out on these big gains because they need to start transitioning to bonds just as their portfolios start to get large because they can’t withstand a big downturn. They cross a million dollars when they reach 60 years old or so, then transition half of the portfolio to bonds and limit themselves to maybe a $50,000 gain in a given year. If I have two to three times the minimum needed, I can stay invested in stocks because I know even if I lose 50% in a given year, I’ll still be set for retirement. I can then take advantage of the opportunity to have really big gains.
If you want to stay fully invested in stocks and get that extra return like me, you don’t start when you’re in your fifties or even your forties. You need to be putting money away regularly when you are in your twenties. If you can find a way to put $5000-$10,000 per year into investments when you’re in your twenties, by maybe buying a smaller home when everyone else is buying big homes, or buying older used cars when others are buying new, you can set yourself up to have much more than the minimum to retire. Then you won’t need to give up return by putting a bunch of your portfolio in bonds either.
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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.