Question about Bonds?

[jc3900]

Ok, for most portfolios it seems that 90% equity 10% bonds is an aggressive portfolio. Now, lets just say I am 20 years old and won't use my investment savings for at least 35 years. Why when I am in my 20's would I want to have any bonds in my portfolio? Wouldn't a 100% equity be better for a very young investor?

[meaghanchan]

Wouldn't a 100% equity be better for a very young investor?

It might, or it might not. There a couple of compelling reasons to have at least a small portion of bonds in your portfolio, although if you look at the reasons and decided that 100% equity was better for you, I wouldn't say that that's a wrong decision, and it's certainly one many people have made.

Some reasons you might want some bonds in your portfolio:

1. They reduce volatility a great deal for a very small reduction in expected rate of return.

2. There is a chance (albeit small) that bonds will outperform stocks even over your very long time horizon

3. Get the rebalancing bonus- if you rebalance to a target allocation (say, 90/10) you will be selling stocks when they are high and buying bonds when they are low, or selling bonds when they are high and buying stocks when they are low.

[disneysteve]

2. There is a chance (albeit small) that bonds will outperform stocks even over your very long time horizon

More importantly, there will be periods when bonds outperform stocks in the shorter term which helps cushion the bear markets.

Vanguard S&P 500 index: YTD: -8.71%; 1 year to 3/31: -5.17%

Vanguard Total Bond index: YTD: +2.43%; 1 year to 3/31: +7.70%

So for the past year, my bond fund has outperformed the stock fund by 12.87%!

[Scanner]

Good point - look at my frustration with Large Caps.

My large cap performed (off of memory) for 10 years: 5.83%

The total bond index Steve referenced performed for 10 years 5.78%

So. . .for much less risk the bonds nearly matched the blue chip stocks performance for the last 10 years in performance.

So, in a way, wouldn't you rather be a bond holder than a stock holder? At least being a bond holder, you are paid first, shareholders second.

[jIM_Ohio]

T Rowe Price suggests 100% equities for any money not needed for more than 15 years. Meaning when you get to within 15 years of retirement, add bonds.

I generally use 20 years for my asset allocation purposes.

If you go 100% equities, make sure you hold around 5 asset classes in the 100%.

Large cap domestic
Large cap foreign
Small cap domestic
Small cap foreign
Mid cap domestic

optional:
emerging markets
microcaps
value fund
growth fund
sector funds (tech, healthcare, utilities, financials, consumer etc...)

[scfr]

jc3900 - My hat is off to you for questioning the standard formulas for asset allocation! There are certain cookie-cutter type suggestions for asset allocation based on age, etc ... I think they are very helpful as a STARTING place, but I also think folks ought to look a bit beyond those and customize for their individual circumstances.

I am on the opposite end of the spectrum of you ... invested much more conservatively than what the standard formulas say I should be. But I certainly see nothing wrong with being much more aggresively invested, if it suits and makes sense for you.

You may be interested in a blog entry I did on why my asset allocation is so conservative. At the bottom of the entry is a link to a calculator that I liked because it was a really "think outside the box" sort of calculator that took a lot of variables in to consideration:
Asset Allocation / The Smartest Investment Book You'll Ever Read: Scfr's Personal Finance Blog

[kork13]

JC, I'm 21 and currently have zero assets in bonds. I agree with you entirely -- we're so young that I don't really care too much about market volatility. I'm not touching most of my money for at least 30 years. Thus, I'm pefectly fine with an aggressive, all-stock portfolio, at least for now.

While I don't claim to have the best asset allocation, I'm happy enough with it, and I'm comfortable about where I'm sitting. I currently have almost $22k in various investments, both taxable and in a Roth IRA. According to my last quarterly report, I'm sitting with the following allocation: 26% Large-cap, 12% Mid-cap, 30% Int'l, 14% equities (precious metals companies--not the metals themselves), and 18% "balanced" funds (a 'catch-all' fund).

My investments are currently very aggressive, particularly with the high level of international holdings. While I am planning to draw that down to ~20% and transfer into small-cap holdings, I plan to stay very aggressive like this for a few years, and not even start looking at bond funds until I'm ~25 or so.

The short version of my long response -- Focusing on an all-stock/equity portfolio during your younger years is perfectly fine IMO. Yes, you'll want to move toward more conservative investments like bonds once you're older (I'm thinking late 20's), but for now, high-risk investing is perfectly acceptable for us.

**PROVISO: This is fine, so long as you're STABLE in your investing habits, as in not trying to time the markets, sell off in a downturn, etc. DCA your money into whatever you like for a while, and you'll be just fine. Grow more conservative with age, but for now, let the market work for you as best it can. There isn't significant risk with our far-off timelines.

[sweeps]

A while back in an econ class, the prof showed us that having a little bit of bonds gave you basically the same return as no bonds, but with much lower volatility. I think it was in the CAPM lecture, but I don't remember the details.

Having said that I am 100% stocks in my IRAs.

[noppenbd]

I agree with meaghanchan and sweeps. A small amount of bonds (10-20%) is not going to meaningfully reduce your long term return. Most advisors that I have read encourage everyone to have at least 10% bonds. There is a reason that they recommend this, because psychologically you are much more likely to stay the course with your investments if you portfolio is less volatile. Some people can stomach those roller coaster rides but I think most people need a little more stability, even at a very slight cost in return. When I started investing 10 years ago I went full tilt with 100% equities. Even though I am still far enough away that I really don't need any bonds in my portfolio, I now keep around 15% to reduce volatility (at 32 years old).

[Broken Arrow]

Bonds can also serve as a good diversifier, since it traditionally has inverse beta. Of course, it's not the only option, but I myself have 90/10 in my 401k. Then again, this is dialed down in order to accomodate my Roth, which is going to be aggressive and 100% equity.

[jc3900]

So what is the concenses? I don't care about volotility if I am not going to touch the money for 35 years. So does that mean I go for 100% equity and then as the years pass, slowly start to build an allocation of bonds.

[noppenbd]

So what is the concenses? I don't care about volotility if I am not going to touch the money for 35 years. So does that mean I go for 100% equity and then as the years pass, slowly start to build an allocation of bonds.

If you truly will not touch it (meaning not pulling out $ into money markets when the market drops 20% in one week), then mathematically you want the highest possible return, which would be 100% equity. But just know that it may be difficult to watch your 401k returns go negative (as many have recently witnessed) without acting. That is why some people elect to go with a small percentage of bonds, even when very young.

[jc3900]

So since it is all psychological, I should go with 100% equity, right! Now the only question would be where the equity should go. I am pretty scared right now of the United States and its financial future. I think I will end up weigting myself towards lending nations and those who don't have a looming financial crash coming to them.

[noppenbd]

Schwab gives it suggested asset allocation for the most aggressive, risk-tolerant, long-term investor as 50% large cap, 20% small cap, and 25% international equity, with 5% cash or equivalent.

You could increase your international exposure by maybe 5-10% at the expense of cash and maybe some large caps but I think it is dangerous to think that you will be safer overall in international than US stocks. If you notice, every time the Dow drops most of the world follows. Any economic crunch that comes will likely not be confined to the US.

Besides, you are investing for the long term, right? So you don't care what happens in the next few years with the credit crunch, subprime, etc.

[jIM_Ohio]

Schwab gives it suggested asset allocation for the most aggressive, risk-tolerant, long-term investor as 50% large cap, 20% small cap, and 25% international equity, with 5% cash or equivalent.

You could increase your international exposure by maybe 5-10% at the expense of cash and maybe some large caps but I think it is dangerous to think that you will be safer overall in international than US stocks. If you notice, every time the Dow drops most of the world follows. Any economic crunch that comes will likely not be confined to the US.

Besides, you are investing for the long term, right? So you don't care what happens in the next few years with the credit crunch, subprime, etc.

International investing also helps hedge against the dollar, because most of the time the dollars invested must be converted to a foreign currency, and the currency can rise relative to the dollar to boost returns without the underlying security even changing in value. See last 3 years+ for reference.

If only 3 equity asset classes are being used (large cap and small cap domestic, large cap foreign) then I think it is too much risk without enough diversification.

If looking at US stocks, you could look at S&P 500 and Wilshire 5000 indexes. You can read that 75% of the Wilshire 5000 performance comes from the S&P 500. So you need allocations to equity classes which do not correllate. This is why I suggest small cap, mid cap and large cap for domestic holdings, plus small cap, large cap and emerging markets needed for foreign holdings. Maybe even slice a pure value fund and a pure growth fund too.

Then allocate between the classes and buy the ones which are lagging. Each class has a period of outperformance, buying low and rebalancing high is important to make money and keep risk in line with expectations.