Why is Your Mix of Stocks & Bonds so Important?
Historically, stocks and bonds tend to move in opposite directions. In other words, when stocks take off for the stratosphere, boring old bonds get left in the dust. Why would anybody bother with a few dinky percent return when you can strike it rich in the stock market gold rush? But then, as happened when the dotcom bubble burst, people stampede to get out of stocks. And where do they put the money? Right - the stodgy but relatively reliable bonds. When one zigs, the other tend to zag.
The underlying cause for this is not only the psychology outlined above. Interest rates, as dictated by the Federal Reserve, further reinforce this phenomenon. When things are going well, the Fed wants to keep the economy from overheating. The primary way to do this is to hike the interest rates. This makes borrowed money more "expensive" which cools off the growth to a reasonable level.
Unfortunately, this is bad news for someone holding bonds. Since a bond is essentially an IOU with a set interest rate, your existing bond is suddenly less worth than a new, freshly minted one. If the IOU in your pocket you bought yesterday has a 6% interest rate and a new one today has 7%, you probably feel a bit gypped. And if you bought shares in a bond fund, which is what most of us choose to do, the value of your fund shares take a hit with each rate hike.
On the other hand, the Fed is quick to slash the rates when the stock market takes a tumble. Then you're suddenly sitting pretty with an IOU that brings in MORE than a new bond would, and for a bond fund the value of your shares go up.
With this in mind it is easy to see why bonds work as an effective hedge against stock market swings. If you keep 30% of your savings in bonds and 70% in stocks, you will do well when the stock market rallies. The 30% in bonds will not grow as fast as your stocks, but at least you have a reliable dividend income to fatten up your bottom line. However, when things head south those 30% in bonds will provide a soft cushion. While you may be 20% in the red on your stocks, the OVERALL situation isn't so bad once you consider the appreciation of your bonds and the good old cash dividends.
However, not all bonds are created equal. These IOUs have different lengths, which affects how much the prices will swing. If you have a bond that is due in one year, you are less vulnerable to sudden price swings. A 30-year bond bought at the peak or bottom have many years to either underperform or exceed the rest of the market, which makes the impact of rate changes the more forceful.
Another thing to consider is the class of bond. A US Treasury bond is about as safe as they come - you know Uncle Sam will pay up next year - or 30 years down the road. A corporate bond in a struggling company may go belly-up before you get to cash in your bond, but on the other hand you may get twice as much return on your investment. The more risk you take, the juicier the potential returns.
For most people, the easiest choice is to go with a bond mutual fund. There, you only have to decide between short, medium or long term investment, and whether to go with a treasury, muni or corporate bond portfolio. Some companies have different specifics on what is what, so you're wise to do your homework to find the fund that works best for you. Vanguard and Fidelity are respectable bond fund companies to consider.
Last but not least, what is the ideal balance between stocks and bonds in your portfolio? There is no one-size-fits-all answer to that. Some claim your age is a good indicator: a 30-year old should have 30% bonds, a 55-year old should have 55% bonds. I think that's a bit too simplified. If you have a stable economic situation and don't mind taking risks, you can be 60 years old and have 90% in stocks and only 10% in bonds, while a risk-averse 25-year old doesn't have to be ashamed about an even 50/50 split between stocks and bonds. The bottom line: the more risk you can tolerate, the higher percentage of stocks you should have.
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