Bonds as Investments

When people think of asset allocation for longer term investing, they usually think of the stock market, and stocks are considered to comprise the growth component of one’s portfolio. Bonds are considered to be one of the assets of the income component, which suggests that there is a lot of difference as far as growth is concerned between stocks and bonds.

People look at the average return for stocks over a long period of time, and come up with numbers like 10% for stocks, and see that over this period of time, bonds deliver lesser amounts of growth, about half of that of stocks. They then surmise that since on average, stocks perform twice as well, they are to be preferred to a significant degree generally, especially among those who are looking to grow their portfolios more aggressively.

The degree that this conclusion is a valid or preferable really depends on the overall market conditions of the day though. Stocks can go through many years of performing very well, and they can also have lulls where they do not perform very well at all, on the long side anyway, meaning buying them and holding with the expectation of capital gains over time.

In a bear market for instance, which can last several decades at times, it would certainly be a misnomer to use the word growth to describe stock portfolios when they instead may be moving in the opposite direction, losing money instead of making it.

Whether or not you continue to hold them through these bearish periods or not does not absolve them from the impact of this fate, as even if they go back up and become profitable again, there is still the opportunity cost of doing something else with your money during this down phase, which even includes doing nothing.

People just don’t put their money in a box at home though waiting for the market to turn around, they invest it, in something else. U.S. treasuries for instance are considered to be risk free investments, so we always have to use that as a benchmark for any other form of investing, and this includes the stock market, investing in other bonds, and everything else.

The View and Approach of the Investment Industry Generally

While there may be times where it is clearly better to be more invested in the stock market, this is not always the case, and often it is not. Bonds can therefore be a better choice over stocks at certain times, for purposes of growth, even if one is looking to grow one’s portfolio rather aggressively.

The most aggressive approach with stock market asset allocation is to go with the trend with stocks and look to take advantage of both bull and bear markets, but few traders are up for taking on this task themselves, and this is the sort of thing that has people turning to hedge funds. Short of that, one may still time their investments to be more or less invested in the stock market and more or less invested in the bond market as an alternative, if growth is the goal.

The investment industry, especially the mutual fund industry, who has a vested interest in our minimizing investment decisions and changes, want us to simply go long the market and stay the course. Any strategy involving market timing is seen as counter to this, as a threat even, and much effort is spent on convincing investors that they do not have the skills to seek this, or even that it cannot be done effectively.

Since we’re not supposed to be able to time markets, being in more when conditions are good and more out when they are not, the only other strategy that is left is just to listen to them and stick to the buy and hold. Concerns of risk management get thrown out the window pretty much, and the most you will tend to see is people doing a little less of this in their later years when their ability to stay this course becomes lessened due to reduced time horizons.

Successful professionals will tell you that success in investing is first and foremost managing risk properly, and that you can and should use market timing to guide you, and this is what is behind their success. Even those minimally informed will tend to be pretty aware of broad market characteristics such as whether we’re in a bull or bear market, and even better analysis is readily available.

We’re just told to maintain most of our holdings in stocks regardless, and as time goes on, gravitate toward bonds more, but still stay significantly in stocks until we’re at least well up there in years.

The amount of reduction in one’s stock holdings that is recommended used to use a formula where you would deduct your age from 100 and this is the percentage of your portfolio that you should have invested in the stock market long term. We’re now seeing that extended to 110 or 120 less your age, meaning that someone 70 years of age would have half of their portfolio in stocks and the other half in bonds.

Aside from this being highly dependent on one’s individual circumstances, needs, and resources, when one is 70 years old, their time horizon isn’t long enough to ride out a significant bear market, and the risk of them doing what you aren’t supposed to do, sell at a loss, can be too high.

We may wonder why investors this age should even ever consider being in the stock market, at least with the buy and hold strategy, at this age, if they expect to need the money from these investments at some point anyway.

Bonds Are More Stable Investments

While bonds certainly do fluctuate, and can fluctuate quite a bit when interest rates fluctuate a lot, investing in bonds is generally more stable than stocks, especially in stable interest rate environments such as what we see in today’s economy.

Inflation tends to move with growth, and growth tends to elevate the value of stocks and depress the value of bonds. Therefore, in periods of high growth, stocks can become the clear better choice. Aside from rising interest rates devaluing bonds, people move their money out of bonds and into stocks more during these periods, further depressing bond prices and increasing stock prices.

At other times, it is not uncommon for bonds to outperform stocks, especially since bonds deliver income independent of price, the interest rate that you signed up for so to speak when you bought the bond. Some people may just hold the bonds to maturity, and some buy long term bonds such as 30 year treasuries with no intention of selling, and just look to capture the interest.

While it generally does not make a lot of sense to hold stocks long term regardless of performance, depending on one’s investment goals, holding bonds long term or being long the bond market long term can often make a lot of sense. This may not be the ideal approach, as one may still be better served to reallocate one’s assets according to market conditions, the buy and hold strategy is both easy and popular and does take the risks of messing up this market timing out of the equation.

In times of trouble, the fact that bonds are less volatile than stocks can certainly be a plus, but with bonds, whether or not one is seeking to even trade them versus just holding them to maturity becomes more of an open question. Bonds do have inflation risk, meaning that the income that you receive from them can become less valuable than expected due to higher inflation, but this is usually less of a concern than seeing your stock portfolio’s value drop significantly, especially if you need to liquidate it for income purposes.

Seeking the Right Amount of Bond Allocation in Portfolios

We certainly aren’t going to determine what one’s ideal allocation between stocks and bonds would be simply by using simple rules of thumb based upon one’s age. There are simply too many other factors involved, and ones that may be even more important than one’s age and time horizon for investing.

Generally, while we want to look to buy stocks low and sell high, we want to do the opposite with bonds as far as interest rates go, buy them when interest rates may be expected to decline.

So when interest rates are higher and are declining, this is the time to move more into bonds, especially if we are looking to achieve capital gains from them. People often will just go for the interest that they bear though, but they pay higher interest when interest rates are higher, and this is what we want generally.

People generally don’t look to buy bonds more at certain times than others based upon interest rates, at least not individual investors, although institutional investors certainly pay a lot of attention to this.

As a rule of thumb though, when the stock market is struggling, there is a movement out of stocks and into bonds that occurs, and this can certainly be a good strategy. The momentum created by this can influence things all by itself, driving stock prices down and bond prices up, and there are also fundamental reasons to consider this as well, when the bear market is driven by a lack of economic growth.

Aside from that, as one moves along in years, toward retirement or beyond it, one should seek more stability in one’s investment portfolio, the kind of stability that bonds provide more than stocks do.

Drawdowns matter more when you actually have to draw your portfolio down, so the more likely this will happen, and the greater extent that it may, means that you want to pay more attention to fluctuations in the value of your investments lest you have to realize these losses not just on paper but with real losses.

The reliable income that investment grade bonds provide also naturally benefits more mature investors, who are more looking to reap the value that they have sowed with their investments over the years. Bonds lend themselves more to this reaping, due to the way they hold their value more reliably overall, which includes both the stability of their price as well as the stability of their returns.

Bonds, from an investment perspective, aren’t just investments that mature investors should be looking at, and even younger investors, even those who may be decades away from needing to cash them in, should consider bonds, in certain market conditions at least.

In spite of whatever our objectives are with investing, it is the market that has the final word, and we always need to look to the market for guidance in crafting our investment strategies. To the extent that we ignore this, we may be putting ourselves in positions where we may fail to achieve our even approach our goals, and it is never wise to blame the market when the blame should instead fall upon us.

With this said, if one is looking to pay less attention to the markets, and to the extent that we do, bonds certainly are a safer way to do this, where the consequences of this inattention will have less of an impact.

Bonds do deliver a lower rate of return over the very long run, but this does not mean that this will be the case over a certain number of years, and even when this is the case, they can be quite desirable anyway, due to their greater reliability.