We believe portfolio construction begins with the most basic allocation between investments that offer a greater chance of appreciation (stocks) and those that provide portfolio stability (bonds). Decisions made at this level are the most critical in determining how well behaved your portfolio returns will be.
In our investment strategy, the asset classes in Stability are
- Short Money, which is fixed-income investments with a maturity date of two years or less;
- U.S. Bonds, which generally pay a higher interest rate the longer their duration and the worse their credit quality but drop in value when interest rates rise; and
- Foreign Bonds, which can balance domestic currency values and interest rates with what’s happening in the rest of the world.
Investment advice has a lot of noise when it comes to recommending how much Stability a portfolio needs. This is especially highlighted by this prospective client question we received:
One financial manager recommended that I invest 100% of my assets into stocks while another recommended investing in bonds as well – what do you recommend? What does the ideal portfolio for me look like?
The answer to this question is rooted in the reason bonds have a place in portfolios.
Reason 1: You have withdrawal needs.
The stable asset classes are like the iron rods that support a sailing ship. They don’t make the ship go faster, but they do keep it from capsizing in a storm.
Generally speaking, investors in or approaching the portfolio withdrawals of full or partial retirement benefit from having at least five to seven years of their withdrawals allocated to Stability.
A Stability allocation helps you have enough money to meet your withdrawal needs by dampening the volatility of stock returns. However, having too much in bonds means that you might not have enough growth and end up running out of money.
An Appreciation allocation helps you have enough growth in your portfolio to compound your savings to meet your financial goals. However, having too much in stocks risks having to take money out after poor market returns early in the sequence and therefore not having enough money remaining to grow when the markets recover.
An all-bond or all-stock portfolio can be projected and the difference between them measured, but the value of not running out of money when making withdrawals cannot be measured. That is why the optimum asset allocation is priceless.
One standard deviation of 7-year stock market movements is all positive. For this reason, we recommend having 5-7 years of your withdrawal needs invested in bonds. This way, you likely won’t have to sell your stocks when the market is down.
Reason 2: You can afford to have bonds.
Those who do not have upcoming portfolio withdrawals often benefit from an all-stock portfolio to give the assets the best chance to grow to meet your financial goals. However, if you are ahead on your savings goals, you can afford to have more bonds than is strictly necessary.
Why would you want to have more bonds? Most of us don’t. However, some people struggle to stay calm during market downturns.
We call getting out of the markets entirely “flat-lining” as the growth on your portfolio stops. It is almost always a poor investment choice. If you sell to cash when the markets go down, it normally ruins a retirement plan and impoverishes an otherwise brilliant investment strategy.
If you feel that you would be tempted to sell to cash during market volatility, then it is better to take action now to protect your portfolio.
One option is to carry a bond allocation you don’t technically need in order to calm your nerves.
Another, is to try to cultivate a feeling of preparedness by being a student of the past. Science tells us that we feel a stress response when we feel unprepared or out of control. If we feel prepared, the same stimulus will produce a challenge response. Challenge responses, unlike stress responses, put us in a place to excel.
And the last one I will mention here is to simply delegate your investment management to someone who will protect you from the big mistake and then don’t peek at how the portfolio is performing.
Photo by rashid on Unsplash. Image has been cropped.
