Bonds have been getting a bad rap recently. Investors have been reducing their bond allocation for years as the stock market rises to new highs. Some investors, especially younger ones, are even talking about eliminating their bond allocation altogether and holding 100% stocks.
People have their reasons for avoiding bonds. They are worried about the current low interest rates and the news that the Federal Reserve will raise rates in the future. They are worried that bonds do not go up as much as stocks, and investors are having a fear of missing out on potential stock gains. Investors are also losing their fear of the stock market, forgetting that the stock market can drop over 50%, as it did during the financial crisis.
The Case for Bonds
However, there are many reasons to include some bonds in your portfolio, even in today’s market:
Stock and bond returns are relatively uncorrelated, providing diversification benefits
One of the benefits of holding both stocks and bonds in a portfolio is their relatively uncorrelated returns. When stocks overperform, bonds tend to underperform and vice versa. For example, during the financial crisis in 2008, U.S. stocks returned -37.0%, while U.S. bonds actually rose by 5.1%. During the Great Recession, investors fled stocks for the safety of U.S. bonds (especially U.S. Treasuries). Holding bonds during these turbulent times softened the heavy losses that nearly all investors experienced. On the other hand, when the stock market is rapidly rising, bonds tend to underperform.
The exact correlation between stocks and bonds is not constant; Fidelity shows a nice graph of the correlation between stocks and bonds over time. The correlation between stocks and bonds over a 5-year period stays between 0.5 and -0.5 most of the time (two assets that are perfectly correlated would have a correlation of 1).
Bonds reduce the risk of your portfolio
By allocating a certain percentage of your portfolio to bonds, you reduce the volatility of your portfolio. While you reduce the expected return of your portfolio by adding bonds, you also sleep better at night, especially when the fear in the market is at its peak.
My experience is that most people cannot handle a 50% drop in their portfolio. Bonds help cut the maximum loss of your portfolio. As Jim Dahle rhetorically asked in his defense of bonds, if you want 100% stocks in your portfolio, why not 110% stocks? How about 150% stocks? You can actually do this by using leverage, either directly by buying stocks on margin, or indirectly by not paying off low-interest loans such as a mortgage, student loans, or auto loans.
Don’t worry about the very low interest rates
Current interest rates are only one piece of the puzzle in determining bonds returns. Remember that yield does not equal return. Companies can default, and your return will typically be less than the stated yield.
When most people think of interest rates, Treasury bond yields or the federal funds rate usually are the first things to come to mind. Treasuries are assumed to be risk-free, but corporate bonds are not. If corporations default at a less-frequent rate than expected, then you get to keep more of the higher interest rate that the corporation promised to pay. This would boost your returns. Interest rates could rise and you could still make money if the economy is good and few companies go into bankruptcy.
How Much Bonds Should Be In My Portfolio?
So if you’ve decided to add bonds to your portfolio, how much of your portfolio should you allocate to bonds? Of course, this is a personal decision based on your own risk tolerance, but let’s look at some rules of thumb that financial advisors have given investors over the years.
Age in bonds rule
One of the classic asset allocation rules of thumb was to invest your age in bonds. So a 30-year-old new attending physician would have 30% of their portfolio in bonds and 70% in stocks, while a 65-year-old retiree would hold 65% in bonds and 35% in stocks. This works well, but tends to be more conservative than what most investors prefer today.
Especially at older ages, I think that the age in bonds rule is too conservative. It’s too conservative for retirees because they need the boost of higher stock returns to maintain the value of their portfolio as they deplete it over time. The 4% safe withdrawal rate popularized by Trinity University researchers required retirees to hold at least a 50% stocks / 50% bonds portfolio. If they held a 25% stock portfolio, the probability of outliving their money declined to an unacceptable level. It is important for even retirees to hold a significant portion of their portfolio in stocks.
Age – 10 or Age – 20 Rule
People have tweaked the age in bonds rule by introducing modifications to the rule, such as bonds = age – 10 or bonds = age – 20. Essentially, this allows younger investors to hold a minimal amount of bonds in their portfolio.
Bond Allocation of Target Date Funds By Age
Vanguard has many target-date funds, which are excellent alternatives to creating your own index fund portfolios. If you want to leave the asset allocation to the people at Vanguard, you can just determine your expected retirement age, and purchase the appropriate target-date fund. It is instructive to see what Vanguard believes to be the ideal asset allocation for people of different age groups.
The table below shows the bond allocation of Vanguard’s various target-date funds. The age listed assumes that you retire at age 65.
| Age | Target Date Fund | Bond Allocation |
| 22 | 2060 | 10% |
| 27 | 2055 | 10% |
| 32 | 2050 | 10% |
| 37 | 2045 | 10% |
| 42 | 2040 | 13% |
| 47 | 2035 | 21% |
| 52 | 2030 | 28% |
| 57 | 2025 | 36% |
| 62 | 2020 | 44% |
| 67 | 2015 | 56% |
| 72 | 2010 | 70% |
Here is Vanguard’s bond allocation of their target-date funds by age in chart form:
Note that there is no age where Vanguard recommends a 100% stock portfolio. They always have at least 10% bonds up to age 40.
Conclusion
There is no “right” bond allocation. How much bonds you include in your portfolio is a personal decision that is based primarily on your tolerance for risk. Of course, never tweak your asset allocation based on how the market is doing. It seems obvious, but you see more and more people asking whether a 100% stock portfolio is appropriate. You only see that in a strong bull market. Pick a bond allocation, and slowly increase it as you get older and get closer to retirement.
My bond allocation is 10% of my portfolio, which will slowly increase as I get older. Keeping the Trinity University study in mind, I never plan to have more than 50% of my portfolio in bonds.
What do you think? What is your bond allocation? How do you plan to increase it over time? How much bonds do you plan to hold in retirement?
” It seems obvious, but you see more and more people asking whether a 100% stock portfolio is appropriate. You only see that in a strong bull market.”
So true. I learned this in the tech bubble leading up to the 2000-2002 bear market, before which I was 100% in equities. Like many novice investors I thought I could handle a large drawdown, but I was wrong. I moved to 75:25 in the aftermath, in my late 30’s and now am about 65:35 in my early 50’s.
If anything, the prolonged bull market has made me want to be less aggressive in my equity allocation, which is the exact opposite as I felt in the late 90’s.
Spoken like a wise, battle-tested market veteran.
My bonds are currently part of my 401 k with my ira being all stocks. The total allocation is near 15 percent which hits the age – 20 rule, though unintentionally. I have nothing wrongs with people being aggressive on stocks if they are planning to work another 20 years. Also as the net worth increases I think switching to more bond allocation makes sense. Focus on preservation instead of growth.
I agree, DDD. There’s no need to go all-out with stocks if a more conservative portfolio makes you more likely to “win” the game. However, remember that maximizing the probability of “winning” the retirement drawdown game using the 4% rule requires at least a 50/50 stock/bond portfolio.
Thanks for the post. If I read this correctly, the main gist is that bonds reduce risk in a portfolio and are anticorellated with equities. Unfortunately I disagree with most of this premise.
1. Over the long haul bonds are more likely to be correlated with stocks than anticorrelated. Chris Cole does a very good job at showing this: http://www.artemiscm.com/welcome#market-views (Rodman paradox, page 5). Bonds have only beem anticorrelated 11% of the time which has occurred primarily in the last 30 years.
2. I disagree that bonds reduce risk in a portfolio. The risk is determined by the term and interest rate. We are at 5000 year lows in rates. If rates start rising, it would cause many bubbles to pop including the equity market.
As a side note, I find the age formulation for bond allocation to overlook what term/duration of bonds to use.
Very interesting read, thevaluedoc. The stock/bond correlation graph appears very similar to the graph from Fidelity I included with my post. I think an asset that is not very highly correlated with stocks (moderately correlated or anticorrelated) using Artemis’s terminology, is helpful for a portfolio. Many people advise adding international stocks to a portfolio for diversification, and international stocks are much more correlated to U.S. stocks than bonds are.
I have 25% in VCLT, Vanguards Corporate Long term Bond ETF, I had VCIT with intermediate term corporate bonds, but the coupons are higher in the long term bond fund.
Rule #1, don’t lose money. If you’re 100% equities, you’ll lose a lot of money in the stock market corrections…
I really enjoy back-testing portfolios and asset allocations at http://www.portfoliovisualizer.com. Kinda addictive.
Hopefully this link will work:
https://www.portfoliovisualizer.com/backtest-asset-class-allocation?s=y&s=y&mode=2&startYear=2007&endYear=2017&initialAmount=10000&annualOperation=0&annualAdjustment=0&inflationAdjusted=true&annualPercentage=0.0&frequency=4&rebalanceType=1&portfolio1=Custom&portfolio2=Custom&portfolio3=Custom&TotalStockMarket1=100&TotalStockMarket2=50&TotalStockMarket3=25&LongCorpBond3=25&REIT3=25&Gold2=50&Gold3=25
Backtesting portfolios are interesting, but as they say in the disclaimer on any mutual fund ad: “Past performance are not necessarily indicative of future returns.”
What’s more interesting is to run that same back test for 2000 to 2010
We hover around twenty percent bonds or bond equivellents (CDs and mortgage prepayment). That matches my risk profile.
Very nice, sounds like you’ve found your optimal bond allocation for your risk appetite.
I totally agree with you. I held 100% in stocks until I saved up $100k. At that point, I added 25% to the total bond fund. I was happy that I did because the Great Recession came shortly after and the bonds helped to reduce some of the losses. At this point, we follow 110 minus our average age in stocks. That feels like a reasonable balance.
Nice. Looks like you use the Age – 10 bonds rule.
Interesting discussion. I have different goals for my retirement accounts (401k, Roth) and my taxable account. I don’t plan to access my retirement account funds until at least age 60, so I hold only 10% bonds. On the other hand, in case of an early retirement, I would draw down money from my taxable account. Since I would potentially need to access funds in my taxable account within 5-10 years, I hold a much greater percentage of bonds in my taxable account (35%).
I think it’s reasonable to compartamentalize your asset allocation by retirement versus taxable accounts. There are ways to get your money out of retirement accounts penalty-free if you’re an early retiree.
I thought a general principle was to place tax inefficient instruments (Bonds, REITs) in tax advantaged retirement accounts accounts, while placing tax efficient instruments (e.g. stock index funds) in taxable accounts? Any comments on this? It seems you are doing the opposite.
He values asset allocation (i.e. Holding more bonds in the taxable account that he plans to draw down in 5-10 years) and the value of not touching his retirement accounts over the minor tax inefficiency of holding bonds in taxable.
The bonds in my taxable account are intermediate term municipal bonds, which are exempt from federal taxes.
This is my favorite Vanguard web page:
https://personal.vanguard.com/us/insights/saving-investing/model-portfolio-allocations
It shows you various portfolio models starting with 100% bonds and ending with 100% stocks.
A 50/50 stock/bond asset allocation has had an average annual return of 8.3% since 1926.
100% stocks had a return of 10.2%
Past performance is no guarantee of future results.
I’ve heard many financial pros say to expect lower stock market returns in the years ahead.
Thank you for sharing — it’s definitely a nice way to begin thinking about your risk tolerance.
It is true that many financial professionals, including John Bogle himself, have been predicting lower future stock returns.
Here is what I have settle on after 30 years of investing which included 2 of the worst corrections in market history. My 401k is 50% Index funds, 35% individual stocks and 15% cash. I then sell covered call options on half of my individual stocks which I continually roll over as they expire. The premium received from the call options acts as a interest payment on my cash in my mind. The cash cushions the blow in a down market without the risk of bonds. People need to remember that Bond mutual funds lose money as interest rates increase. Individual bonds won’t lose money if held to maturity but are more difficult for individual investors to buy and manage and if corporate bonds they have the risk of company failure or early buy back by the company if interest rates fall. I always sell Call options at a strike price above the current stock price and usually 4 weeks out so they quickly lose “time value”. This system has allowed me to outperform the SP 500 index over the last 10 years.
I am a novice investor in my late 30’s, and as such, I was 100% all stocks a year ago not knowing a thing about diversification. What a learning curve it has been as I rode this crazy market wave! Thankfully I still came out on top and beat the markets, but now, and based on my age, I am diversified with an 80/20 mix of stocks to bonds, got into non-tradable REITs, crypto, snagged some gold and silver bars, and am planning on buying a rental property (I owned a few years ago and sold before the crash of 2008), all while making sure I am not too heavily weighted in any one asset class. I only wish I had started all of this 20 years ago! Enjoyed this article. Thank you!
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