Why You Need More Bonds as You Get Older
The Fed's stance on increasing money supply has pushed interest rates so low that some experts are jumping on the bandwagon of calling for investors to reduce their bond holdings before interest rates rise.
Some people suggest mild adjustments, such as moving to shorter term bonds. But other experts suggest drastic changes including getting out of bonds completely to avoid the bond bubble. They seem to have forgotten why we need bonds in the first place: They provide stability and safety when markets decide to test our trust in the long-term growth of the global economy.
In the current environment, bonds still play an important role in preparing for a comfortable retirement. This is especially true for folks as they get older because:
You have accumulated more money you could potentially lose in the stock market. The reason we invest in the stock market is to get potentially higher returns, but note the important caveat of "potentially higher" here. There are simply no guarantees, and stock prices can gyrate violently at times of stress.
Bonds, on the other hand, are a contract that the entity will pay you back your principal plus all the interest payments. Except for the possibility of defaults (which for ultra-safe investments like Treasuries is extremely low), you are offered a chance to guarantee the return of a portion of your investments.
As you age, you will be much closer to the amount you need to maintain your lifestyle. Let's say you can already guarantee a pretty good lifestyle with a healthy dose of safe investments. Is it worth the risk to jeopardize the good life in order to potentially earn a bigger number in your account statements?
Older folks have less time to recover from market crashes. The markets have recovered remarkably quickly since the recent financial crisis, but it's not inconceivable to think that it'll take a decade or even longer for the markets to recover from the next major market crash. Can you imagine quitting your job of 40 years and then having to suffer the rest of your life trying to recover from a huge market drop? Even if you don't need the money that's no longer there, how would your outlook change?
High stock allocations actually decrease the safe withdrawal rate. Did you know that having stocks, even with their higher returns, actually decreases the amount you can safely withdraw from your portfolio without the balance being depleted too quickly? Due to the volatility of stock returns, you may be taking too much money out of your account during a market crash to ever be able to recover. For older folks, the stability of an investment portfolio is more useful than one that flies high and crashes hard.
Bonds can actually go up in turbulent times, possibly giving you a rebalancing bonus. Long-term treasuries were up in 2008, a time when everything else was going down the drain. Aside from the huge psychological benefits of having an asset that actually went up, you would have achieved a higher return than investing in either treasuries or stocks alone if you simply rebalanced back to your target asset allocation.
The danger of the recent alternatives to bonds, such as dividend-paying stocks, is that older folks will start believing that the risk characteristics are the same. Sure, dividend-paying stocks can be good investments, but their returns aren't nearly as certain. Bonds act as the perfect diversifier to stocks in a well thought out investment portfolio. Any other alternative just doesn't quite cut it.
David Ning runs MoneyNing, a personal finance site that shares money moves you can make to significantly increase your chances of having a comfortable retirement. He likes to share simple changes that anyone can make, such as picking the best online savings account and figuring out whether a 0 percent balance transfer credit card makes sense.
