Smart Money

Taking Your Financial Medicine

The Role Bonds Play in Your Portfolio

Ben Le Fort
Oct 1 · 5 min read
A woman is holding a handful of perscprtion pills and multi-vitamins
A woman is holding a handful of perscprtion pills and multi-vitamins
Photo by pina messina on Unsplash

Yes, you need bonds in your portfolio. Unless you are under 30, know what you are doing and have the stomach to handle extreme volatility (40% declines) a 100% equity portfolio is not going to produce a pleasant experience.

The difference between stocks and bonds

When you invest in stocks, you have partial ownership or “equity” in a company. As the company profits, you also profit through increased share prices and dividends. When the company does poorly, so do you. Share prices and dividend payouts can be drastically reduced during bear markets and recessions.

When you invest in bonds, you are giving a loan to the issuer of the bond. The bond issuer agrees to pay you back the face value of the loan on a specific date and to pay you interest payments.

Bonds have a lower expected return than stocks but are less volatile.

Stocks and bonds play different roles in your portfolio

Stocks are more exciting than bonds, particularly with interest rates as low as they are right now. However, you may not want too much excitement in your portfolio especially if you are nearing retirement age.

A balanced portfolio will have a mix of stocks and bonds

Vanguard has compiled some interesting data on the expected returns and volatility of portfolios that range from 100% bonds to 100% equities. The following data is from 1926–2018.

100% bonds

20% stocks-80% bonds

40% stocks-60% bonds

60% stocks-40% bonds

80% stocks-20% bonds

100% stocks

These model portfolios tell us something very important. The more we invest in stocks the higher our expected return will be. The 100% stocks portfolio had a 4.8% higher return per year than the 100% bonds portfolio.

However, that higher average return comes with a lot of bumps along the road. The portfolio invested in 100% stocks had a negative return 28% of the time. Compared to 15% of the time for the 100% bonds portfolio.

Not only are you more likely to have years with a negative return with a 100% stock portfolio, but the magnitude of those losses is much higher for stocks. The single worst year for the 100% stocks portfolio was a loss of 43.1% in 1931.

Relative to bonds, when stocks lose, they lose big. It’s easy for people to say they will “ride out the bad years”. However, we never know how we will react when we are living through a market crash. Millions of people sold at the bottom of the market in 2009 and locked in their paper loss into a real loss.

Diversification matters for bonds too

It’s important to not only have a diversification between stocks and bonds but also geographic diversification. This graphic from Vanguard shows the overall volatility of bonds in the U.S, Canada, the U.K, the EU, and Australia.

Source: Vanguard

The results clearly show that a global bond fund that is hedged to an investors local currency reduces the volatility of bonds within a portfolio. Here’s an explanation as to why that is.

A word of caution. It is important to ensure any global bond fund you consider is hedged to your local currency. If it is not, you introduce exchange rate risk and the volatility of your portfolio will increase.

Since one of the primary goals of bonds is to reduce portfolio volatility, the data suggests it makes sense to have exposure to a globally diversified bond portfolio that is hedged to your local currency.

Final thoughts

It is true that a 100% equity portfolio will give you a higher expected return than a balanced portfolio. However, expected returns are not guaranteed. We plan for expected returns but we eat real returns. If the market crashes at the wrong time and you are forced to sell at a loss, you have less money to put food on the table.

Bonds are boring, but they make the investing journey a lot less bumpy. Investing in bonds is taking your financial medicine. It might not taste great going down, but it will help ensure your financial health.

What allocation do you have between stocks and bonds in your portfolio? And more importantly, what data and research did you rely on to come up with that decision? Let me know in the comments.

Don’t forget you can sign up for my FREE personal finance course here.

This article is for informational purposes only, it should not be considered Financial or Legal Advice. Consult a financial professional before making any major financial decisions.

Making of a Millionaire

Stories about money, personal finance and the path to financial independence.

Ben Le Fort

Written by

Sharing the lessons I’ve learned on my journey from debt to Financial Independence. Email me for freelance inquiries:

Making of a Millionaire

Stories about money, personal finance and the path to financial independence.

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