Since the Great Recession in 2008- 2009, stocks have risen about 160%, widely out-performing bonds. In reaction to the Great Recession, the Federal Reserve reduced interest rates to near zero with the goal of re-starting a falling economy. As a result, bond interest rates have hovered near decades-long lows for the last five-plus years. Today, if you were to invest in a 10-year treasury, you’d only receive about 1.6% annual interest. Based on these paltry returns, many investors have asked, “Why should I invest in bonds?” for the answer I’ve turned to one of our partners, Woodard Peay, MBA, CFP®.
Stewart: Woodard, based on the current low interest rates offered by high quality bonds, what would be your number one reason for investing in bonds?
Woodard: Bonds serve to dampen the volatility of a portfolio that includes stocks. Even for investors in a wealth accumulation mode with a distant planned retirement date, many of us are psychologically vulnerable to a sharp stock market selloff, such as when the UK voted to exit the European Union this summer. When panicked stock selling occurs, investors typically move the resulting cash proceeds to either money market or government bonds in a flight to safety. This behavior can even bid up bond prices in the midst of an emotional plea to “Get me out!” of the stock market. In our experience, investors with a significant allocation to bonds are more likely to avoid panic selling and stay focused on their long-term investment goals. Using the Brexit market sell-off example, investors who remained invested saw the markets recover very quickly. Many of those who sold out of stocks are still in cash and have missed the market run-up in the months following.
Stewart: Woodard, is there an ‘ideal mix’ in the allocation between stocks and bonds in a portfolio?
Woodard: We typically start with a ‘conceptual’ allocation of 60% stocks and 40% bonds. Studying history, this appears to be a ‘sweet spot’ allocation where, over the long term, you’ll receive about 75% of the stock market return with about 40% less volatility. From this conceptual beginning point, we adjust the client’s actual allocation based on a detailed review of their future cash flow needs and tolerance for risks (volatility).
Stewart: Speak a moment about the importance of rebalancing.
Woodard: Having an allocation to bonds provides investors the opportunity to potentially take advantage of significant market volatility. While most seasoned investors agree that attempts to successfully “time the market” are futile, periodically rebalancing a portfolio to a target allocation can add value over time. For example, assume that an investor has a target allocation of 60 percent stocks and 40 percent bonds. Following a significant stock market decline, the stock allocation may drop to 50 percent if bonds retain their value. To move back to the target allocation, some bonds can be sold and the proceeds used to purchase more stocks (at the prevailing lower prices). Once stocks rebound and make new highs, rebalancing allows you to take some profits. This rebalancing process enforces a buy low, sell high strategy.
In summary, an allocation to high quality bonds can reduce a portfolio’s volatility while creating the opportunity to rebalance stock and bond positions to control investment risk and to take advantage of market volatility.