1) Bonds reduce portfolio risk by reducing volatility.
Creating a portfolio is like putting the pieces of a puzzle together. Portfolios are built by assembling pieces of stocks, bonds, and cash, with possible additions of real estate, commodities, & alternative investments. Modern portfolio theory taught us that by combining securities that don’t follow each other, when one leans left the other right, we are likely to achieve a more stable return. Bonds tend not to move in tandem with stocks. In finance terms, they have a low correlation to stocks. So if stocks drop 15%, bonds may decline but less than 15% or they may even rise. Bonds are the pieces that reduce short-term, gut wrenching swings in the portfolio’s value.
A recent example. From October, 2007 to March, 2008, the S&P 500 had lost around 16%. The Lehman Aggregate Bond Fund, used to represent the broad U.S. bond market, was up about 4%. A portfolio split 50/50 between the S&P 500 & the Lehman Bond Fund, would have returned -6%.
2) Bonds protect the downside.
While similar to #1, protecting the portfolio’s value is of special importance to retirees who are withdrawing funds regularly to supplement their income. When cash is withdrawn from a 100% stock portfolio during down markets, the distribution takes a larger piece of the portfolio than if the markets were up, and that piece is gone so it can’t come back when the markets climb.
For simplicity let’s consider a portfolio made up 2,000 shares of an exchange traded fund, IWV, that represents the U.S. stock market. The price per share has plummeted to $78. Each month the retiree withdraws $1,000 for living expenses. 13 shares are sold at $78 to provide this month’s withdrawal. Next month IWV has risen to $95 per share. Only 11 shares have to be liquidated in order to withdraw $1,000. The two additional shares that had to be sold at $78 are no longer in the portfolio and able to come back with the market.
In a declining stock market, cash and bonds can provide the income needed. When the stock market comes back, (yes it will rise again) the stock portfolio will not have been depleted so will take full advantage of the rising prices.
3) Bonds provide income.
Bonds pay interest, which makes up most of their return. The other portion of the return comes from the change in the price. Individual bonds typically make interest payments every 6 months. Bond funds generally distribute interest monthly. The interest payments provide stability to a portfolio, and dependable cash distributions to investors. When the markets are performing poorly, during a bear market, interest payments are a stable source of income.
If you rely on distributions from your investments to supplement income. If you do not have other income streams to use when the stock market is declining. If your financial position is such that you are concerned you may outlive your money. Then investing a portion of your portfolio in bonds is wise.
The portion you allocate to bonds could vary from 15% for the aggressive investor with a time horizon over 20 years, to 85% for an investor more concerned with preserving their portfolio and has a life expectancy less than 5 years.
