Why you should have bonds in your portfolio
Bonds are frequently overlooked, but they don't need to be. Investing in this asset class can be an important part of a balanced portfolio.
You scarcely read or hear much about bonds these days. The stock market, especially in recent weeks, grabs the headlines all the time. Bonds just aren’t glamorous. Sure, Michael Milken, “the junk bond king,” brought some glamour and headlines to bonds back in the late ’80s, but they haven’t received that kind of coverage since.
Yet that’s no reason for investors to forget about this important asset class. Bonds are one of the three major asset categories — along with stocks and cash — you should have in a balanced portfolio. Investing in a mix of these assets is a good strategy for achieving your financial goals.
Having bonds in your portfolio can help reduce risk, which is a welcome proposition given the market volatility we’ve seen since the beginning of the year. Stocks tend to be more volatile than bonds — they go up and down further and faster — and that makes them a riskier proposition for the short-term investor. Think of stocks as cleanup hitters. They’re going to hit a lot of home runs, but they’re going to strike out a lot too. Bonds are more like leadoff hitters, the guys who can consistently hit singles and get on base. They can be a stabilizing force amid volatility.
The stock market, like most things, tends to cycle. Right now, the decline seems to be a reaction to the dramatic drop in oil prices and the slowing of China’s economy. Bonds cycle, too, but they’re not as volatile as stocks. Instead, bonds often have acted as insurance by reducing portfolio volatility.
This is because bonds often move inversely to stocks, and this tends to be mostly true when stocks are falling. However, bonds are in an unusual place right now because of historically low interest rates. When rates rise, the value of bonds will go down. But this should not deter you from holding bonds in your portfolio because they are still less volatile than stocks, and if the stock market takes a big hit, bonds usually rise. This means bonds and stocks work in concert with one another in your portfolio.
In designing a portfolio, you want to have a mix of assets that can move inversely under different market conditions. Diversifying in this way reduces your risk and thus your chances of getting hurt.
Asset allocation — holding the right proportion of stocks, bonds and cash for your situation — is important because it can impact your financial and personal goals. However, designing the best asset-allocation model or portfolio can be complex. You need to look at your time horizon and your tolerance for risk.
Your mix of stocks and bonds also should be determined in part by the amount of money you need and when you will need to withdraw it from your accounts. If you don’t include enough risk (think stocks), your investments may not earn an adequate return to meet your goal. However, with too much risk (think not holding enough bonds), the money may not be there when you need it.
For instance, an older person should have fewer stocks and more bonds in his portfolio. A 25-year-old, though, can have a higher ratio of stocks. She’s in it for the long run and can take more risk than someone who’s nearing retirement.
We’d all like to know what will happen to our money in 2016. While we can count on the media to offer plenty of headlines and opinions about the economy and markets, the danger comes when we base our investment strategy on these headlines.
We can’t know what will happen to stocks or bonds, and we can’t outguess the markets. If I could, I’d probably have a cult following. But we do know this: The markets will go up, and the markets will go down. And some parts of your portfolio will do better than other parts.
Having the right mix of stocks and bonds will reduce your portfolio risk and your potential losses. So instead of trying to pick a bunch of hot stocks, investors should stay diversified and goal-oriented — and not forget about bonds.
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This article first appeared on NerdWallet.