Bonds and stock investments offer two different vehicles to achieve your investment goals. Depending on your tolerance to risk and timeline to needing to cash out your investments, different asset mixes are recommended. In the long run, stocks generate higher returns than bonds, but with a higher standard deviation. This means that there is a lot more fluctuation in stocks. You can reduce this general fluctuation by index investing, but you will never be as stable as bond investments.
If you were gambling your play money at the casino, and you simply wanted the best odds to win big, stocks are the way to go. If you want the best odds to win something…any amount, bonds are your choice. However, there is a difference between gambling your play money at the casino and risking your life savings in the stock market. Most people will not want to take as much risk, and you shouldn’t. Diversification through owning many stocks and having a bond component to your portfolio help control this risk and keep your investments safe.
At the time of writing this article, interest rates are at an all time low. The investment return on bonds is driven by interest rates, so bonds are currently paying out on the low end. In addition, if interest rates start to rise, and you’ve already bought your bonds, they will now lose value as they are locked in at the old lower interest rate. If you are investing in a bond fund, as I recommend, the fund will lose some of it’s value as the interest rates rise. So, overall bonds are a lot less interesting today, then they were historically. Therefore I do try to avoid them wherever possible, except for certain cases.
As a general approach, I try to keep my investments in equities as much as possible except for when I will absolutely need that money in the near future. For those cases, I do recommend investing in bonds for the portion that you cannot afford to lose.
Short Term Investment Goals
Short Term investment goals can be categorized as needing to sell your investments in under 6 years. Examples of short term goals might be saving buying a home or buying a car. Generally, you cannot afford to lose this investment. You will need that money for a home for your family or a car to get to work. That portion should be invested in a mix of bonds and high interest savings accounts. However, if you are aiming to buy more house or car than you need, such as that luxury car you’ve wanted, taking a risk with the extra amount in diversified stocks can be justified. As long as you understand that you are taking some risk for a reasonable chance of a better return.
Medium Term Investment Goals
Medium term investment goals can be described as needing to sell your investments in 7-15 years. Examples of this can be college funds for your children or retirement after 65. Keep in mind that with retirement, you do not need to sell all your investments the moment you retire. So even if you are retiring in 3 years, I would still categorize this as a medium term investment goal. If you are retiring at 45, it would be long term.
For medium term investment goals, its time to take more risk and invest in safe equity investments such as diversified blue chip stocks or even better, broad indices of developed countries. Benjamin Graham, a legendary investor, states in his book The Intelligent Investor, that you should diversify into at least 30 blue chip stocks to reduce your risk. In today’s world of ETFs, you can go beyond this with even more diversification to reduce your risk even further.
However it could still happen that in a medium term investment timeline, that all world markets experience a downturn, such as 2008. Although rare that you will lose money by investing in equities for a 15 year period, it is not impossible. Therefore a portion of your investments should be in bonds to protect against this. However, due to the current state of interest rates, I do not recommend having above 50% Bonds for medium term investment goals.
Long Term Investment Goals
Long term investment goals can be defined as investment horizons beyond 15 years, such as retirement and college funds for young children. Long term investments should be mostly or entirely in stocks, especially with today’s low interest rates. Only in rare circumstances has the stock index underperformed bonds for a period greater than 15 years. However it has happened and could happen again. But there is a greater chance you will lose out on large potential gains by only playing it safe with bonds.
The table below summarizes a portfolio breakdown depending on the investment term.
These are my recommendations base on my comfort level for risk. In general, it is preferred to reduce risk as much as possible through diversification before adding bonds.