Should you invest in bonds?

Bonds don’t offer much of a return these days. And, their “real return” (i.e., net of inflation) is negative. That doesn’t sound like a great deal. Should they be a part of your investment portfolio?

The short answer is, for most people, yes.

The 10-year Treasury bond currently yields ~1.3%. Vanguard and Fidelity’s flagship intermediate term bond funds also yield ~1.3%. When you factor in taxes, inflation (currently running greater than 2%), and any fees you pay to a financial advisor, you end up with less than you started with. How can that be a good deal?

I didn’t say it was a good deal but what are the alternatives?

A good investing framework is to think about different asset classes. That’s financial jargon for describing investments that have differing risk and return characteristics and the three most common asset classes are stocks, bonds, and cash. Within those asset classes, there are sub-groups such as US and international, large and small stocks, junk and investment-grade bonds, long-term and medium term bonds, etc. but we can stick with the three broad groupings.

There are other asset classes — examples are commercial real estate, derivatives, commodities, private equity and venture capital — but those are more appropriate for institutional investors and have shortcomings for individual investors.

If you keep your investments away from bonds, where do you go instead? That really leaves stocks and cash. If you think bonds offer paltry returns, then you won’t love cash. Currently, its yield is roughly 0% — again, negative after factoring in future inflation.

You can and should invest in stocks and they’ve had amazing performance since the Great Recession of 2009. Over the past 10 years, they’ve averaged annualized returns of 16% — almost unheard of over a 10-year period. And, over the past 100 years, stocks have averaged 10% annualized returns (still quite good). The challenge with investing in stocks, as everyone experiences every 10 years or so, is that they can and do drop in value — sometimes dramatically — and that causes great anxiety in many people.

So, why include bonds?

Simply put, bonds — especially US Treasury bonds — are the ballast for your life savings. When your investments sail through stormy waters, you rely on the bond portion of your portfolio to hold its value and keep your ship afloat. Similar to insurance, you de-risk the future by accepting lower returns now in exchange for more predictability. Bonds can also drop in value but their dips are unlikely to be as dramatic as with stocks.

How much of your portfolio should be in bonds?

It depends on a few factors — most notably your age, your income, and your net worth. Essentially, younger, higher income and higher net worth people have the luxury of being able to take more risk with their investments and thus should tend toward a lower percentage of their asset allocation dedicated to bonds. They have more years, more income, and/or more savings to buffer themselves when the stock market inevitably does poorly.

So, for example, a 30-year old may have little or no bond allocation for her retirement savings but for a 65-year old person about to enter retirement, it may make sense to have 50% of her portfolio in bonds. A retired 65-year old has less time to recover from a severe downturn in stocks and no earned income to fall back on.

Bonds aren’t sexy but they can play an important role by stabilizing your portfolio and protecting your net worth.

PS:  You can read more about the basics of how bonds work here.