Deciding on the Bond Percentage for Your Portfolio - dummies

Deciding on the Bond Percentage for Your Portfolio

By Russell Wild

To figure out what percentage of your portfolio should be in bonds, there’s just one thing to remember: There are no simple formulas, because each person’s financial situation is unique. One factor, however, is key: volatility.

Minimize volatility in your portfolio

The long-term return on all bonds, judging by the past 80-plus years, is about half that of all stocks. The real return on bonds (after inflation but before taxes) is about a third that of stocks. For the average taxpayer, the after-tax, long-term return on bonds is roughly a quarter that of stocks.

So what percent of your portfolio do you want in bonds? If an easy formula existed, it would be this:

Ideal percent of your portfolio in bonds =
The necessary amount and no more (or less, for that matter)

The “no more” part is the easier part of the formula. The answer is 75 percent. No kidding. Except perhaps in very rare circumstances, no one needs or wants a portfolio that is more than 75 percent bonds. Why? Because stocks and bonds together provide diversification. With all bonds and no stocks, you lack diversification. Diversification smooths out a portfolio’s returns.

Believe it or not, even though stocks are much more volatile than bonds, a modest percent of stocks added to a portfolio of mostly bonds can actually help lower the volatility of the portfolio. To include less than that (or more than 75 percent bonds) raises volatility and lowers the odds of favorable returns both over the short run and long run.

So why would anyone ever want to go there? Unless you have good reason to expect an economic apocalypse anytime soon (you don’t), it doesn’t make a whole lot of sense to invest only in bonds.


Maximize return in your portfolio

The highest returning portfolios over the past few decades — over any few decades, for that matter — are made up predominantly of stocks. But those are also the portfolios that go up and down in value like popcorn on a fire. So the question “How much do you need in bonds?” is largely a question of how much short-term volatility you can or should tolerate.

How much volatility you can or should stomach, in turn, is largely a factor of time frame: Are you investing for tomorrow? Next year? A decade from now? Five decades from now? If you run an endowment fund, or if you happen to be immortal, your timeframe may be infinite. Most of us human-being types will want to tap into our treasured nest egg at some point. But when?

To compare the volatility of bonds versus stocks, take a look at this figure. Bonds’ long-term gains pale in comparison to stocks, but when things get rough, bonds don’t take it on the chin as stocks do. The figure shows the best and worst returns for stocks and bonds (as measured by the S&P 500 Index and the Lehman Brothers [which later became the Barclays] U.S. Aggregate Bond Index) since the Great Depression.

[Credit: Illustration courtesy of Vanguard]
Credit: Illustration courtesy of Vanguard