When you’re trying to figure out the right mix for your investment portfolio, don’t forget about bonds. It can be tempting to focus on funds that invest solely or heavily in stocks. But bonds, which tend to have lower returns, have an important role to play, too.
To compare: Over the past 90 years, the average annualized return for U.S. stocks has been around 10%. That’s more than double the average gain for bonds.
“It’s really easy to look at higher historical returns for stocks and say, ‘All I want is to own stocks’,” says Peter Lazaroff, co-chief investment officer at Plancorp, a St. Louis financial advisory firm and author of the book “Making Money Simple.”
But while you want the higher returns from stocks, there’s a reason why bonds are a key element to a winning portfolio: They’re relatively consistent. Consider that the worst calendar year for high-quality core bond funds was 1994 when an index lost nearly 3%. Not 30%, but 3%.
Bonds are how big entities, like the government or large companies, borrow money for a set time. The bond issuer pays an annual interest rate and repays the principal amount when the bond “matures,” or reaches its end date. You, the investor, are essentially giving a loan to the issuer, who pays you interest, or the bond yield, in return. Investors often buy bonds indirectly through shares of mutual funds or ETFs, although you can also buy individual bonds.
Here are some basic guidelines for considering bonds as part of your portfolio.
There are two broad types of bonds: high-quality and high-yield. Financial advisors typically suggest sticking to high-quality bonds—often referred to as investment-grade or high-grade—to diversify your portfolio.
Why? Investment-grade bonds are considered a safer bet because their risk of defaulting on repayment is low. Treasury bonds issued by the U.S. government, and bonds issued by corporations on solid financial footing, are considered high-grade.
High-yield bonds, also called junk bonds, are issued by companies with iffy balance sheets. In 2008, an index of junk bonds lost more than 30%, while an index of high-quality investment grade bonds gained more than 2%.
If you are investing in a 401(k) or your own Individual Retirement Account (IRA), look for a low-cost fund or exchange traded fund (ETF) with the word “core” or “aggregate” in its name. These are high-quality portfolios that own a solid mix of investment grade bonds with a five to six years duration. Duration measures how the fund or ETF will fare when interest rates change.
Lazaroff points out that portfolios with longer durations have more than double the volatility, while those with shorter durations, though less volatile, tend to pay out less interest. Many investors find a happy medium in bonds that aren’t too volatile and they don’t pay too little interest. A duration of five-to-six years is often considered just right.
There’s no magic ratio of bonds to stocks that you should have in your portfolio. What’s critical is knowing your own sensitivity to the market’s spikes and slumps, and learning to invest accordingly.
“Mixing bonds into your portfolio is how you dampen the overall risk of your portfolio,” says Skip Johnson, a founding partner at Great Waters Financial, an advisory firm in the Minneapolis area.
“Everyone’s risk tolerance is different,” says Johnson. “But owning some bonds even when you have decades of investing ahead of you can help you stick with your strategy.”
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