The Proper Role of Bonds in Your Portfolio

Over the years, as I have spoken to quite a few people about bonds, the various conversations have often taken a different direction, depending on the “environment” at the time.  Take, for example, 1999, when common stocks were on a tear; then I had to explain the reasons why anyone would want to invest anything at all in the bond market.  And in recent times, in this “environment” I’ve actually had to talk investors out of investing too much of their money in bonds. 

These are both examples of what Behavioral Economists call “recency.”   Meaning that we tend to place more emphasis (and trust, appropriately or not) on more recent data even as we ignore older data. 

A more general problem, I’ve found, is that investors don’t understand the role that bonds should play in an investment portfolio.  When you buy a bond you are essentially lending money to some entity, whether it’s a corporation, a municipality, a state, or a country.  In exchange for what is essentially your loan, you are promised a regular payment, usually on a semi-annual basis, plus the full amount of the money you lent returned to you at a given date.  Depending on the circumstances, you may or may not realize the promised returns. 

Bonds are considered “fixed income;” investing in them generally means that you will not gain as a result of growth in the economy.  Bonds are considered safe and therefore have a lower expected return than stocks.  But bonds have two inherent risks, namely interest rate risk and, more importantly, credit risk/default risk.  Interest rate risk means that when interest rates rise, bond prices will fall, given the inverse relationship between them. 

Default risk describes what happens when the entity has gotten into financial trouble and does not return your original investment.  Take for example, Greece; certainly you have heard how the threat of Greece defaulting on their bonds is playing havoc with markets there and across the globe. 

Portfolio strategists view bonds as a way to provide stability to a portfolio.  Accordingly, this approach argues for only buying high quality bonds, i.e. those with the highest credit ratings.  The reason is that you won’t want an economy which is going through a “soft patch” to adversely affect both your stock portfolio and your bond portfolio at the same time.  The whole idea is that bonds should provide a safer haven than stocks, albeit with a lower expected return.

Conclusion

It is my belief that, as part of a sensible portfolio, fixed income investments must be limited to high quality issues.  I also believe that it’s a mistake for investors to overemphasize bonds in a portfolio, simply because they are afraid of a bad economy or bearish stock market.

Over the long term, stocks have always outperforned bonds.  And over time, it is the erosion of purchasing power that is the biggest risk for most people.  Most bonds do not protect you from the ravages of inflation.

In the long-term, you need both equity investments for growth and bond investments for stability.  How you make that allocation decision is the most important determinant of how your portfolio will behave in the future.

To be continued.

Excellent Advice on 401(k) Investing

“Modern Portfolio Theory offers one of the strongest tools available to the rational investor.” – Frank Armstrong

It’s a nice change of pace to have something positive to say about an investing article from the mainstream media. Believe me when I say that finding and commenting on misleading articles can be exhausting.

Well, Forbes’ recent article on Portfolio Calculus For Your 401(k) is nothing short of a breath of fresh air. It is a well-written article which offers a succinct explanation of Modern Portfolio Theory and its practical application to investing in a 401(k) plan.

There is no hype, no promises to “beat the market.” Just good sensible advice. AAII Staff is credited as the article’s writer; AAII being an acronym for the American Association of Individual Investors, a non-profit organization that educates its members about investing and financial planning issues.

The article recommends four very sensible steps to creating a well-balanced 401(k) portfolio.

1. Determine Your Risk/Return Preference
2. Form a Diversified Portfolio
3. Select Mutual Funds
4. Rebalance Periodically

I could not agree more with the process outlined; the first three steps are quite intuitive, and need no further explanation beyond that in the article. Not so with the last step.

Rebalancing

As the article explains, from time to time, you need to “readjust” your portfolio to restore its original balance. Because of market forces, the relative values of the components of your investments change over time. That’s the reason why you diversified your portfolio in the first place (or at least, why you should).

The rebalancing solution may be difficult for many investors for two reasons. First because you may have to sell off some of your “winners” and buy more “losers.” From a psychological standpoint, this may be an unusual and counterintuitive decision for many investors. But merely by virtue of market dynamics, “winners” cannot always be “winners” and “losers” will not always be “losers.” Second, if you have more than one investment account, you will have to decide which one to rebalance and when to do it. This can depend on the options available in your retirement account, cost of transactions, tax considerations, restrictions, etc.

It may not be easy, but periodic rebalancing of your portfolio is essential if you want to prevent it from getting “out of whack.”

Your Entire Portfolio

While the singular aim of the article was to explain what to do with a 401(k) allocation, similar considerations can and should apply to all of your investments. In fact, I believe that you should set up  your entire portfolio at the same time that you are making decisions about your 401(k).

Asset Location

When setting up a portfolio, one factor not sufficiently mentioned, though, is asset location — how you distribute your investments across taxable and tax-deferred accounts, e.g., 401(k) or IRAs.

The goal is to divide your investments in a way that will defer taxes and ultimately provide the best after-tax returns.

Under current U.S. tax law, long-term capital gains and “qualified” dividends are taxed at 15 percent for most taxpayers, and most other investment income (nonqualified dividends, interest and short-term gains) is taxed at marginal rates of up to 38 percent.

Not only are different kinds of income taxed at different rates, but income from tax-deferred accounts isn’t taxed in the year it is earned – instead, all contributions and earnings are taxed when the money is taken out.

While this seems complicated, we can simplify to some extent. In general I recommend that you hold tax-efficient assets like stock index mutual funds in taxable accounts. Tax-inefficient holdings, such as fixed income funds and Real Estate Investment Trusts should be held in tax-deferred accounts, whether it is a 401(k) plan or an IRA.

Conclusion

For any investor, this Forbes article is more than worthy of earning a place among your browser’s bookmarks. Bear in mind, though, that for some investors actual implementation of rebalancing and asset location may pose a challenge.