By Jonathan Scheid, CFA, AIF®
Investing is a series of trade-offs. Every one of us has a finite amount of money, and we must determine how much we want to put where. Placing a large portion of our money in stocks means we might have tremendous upside potential, but it also means we won’t be able to put a lot of money in the cash and bonds that help stabilize some of the ups and downs of stocks. Placing all our money in cash and bonds might not get us the growth we need to meet our financial life goals.
Determining how much to put in stocks versus bonds is a vital decision, one that your financial advisor can help you make with confidence. And the trade-offs don’t stop there. There’s a multitude of asset classes underlying the broad categories of stocks and bonds, and the decisions that we make in selecting each of those asset classes could be the difference between achieving our goals or falling short. Fortunately, there is a sizable body of industry and academic evidence that we can rely on to make informed decisions about these trades-offs.
The bonds we want (and don’t want) in our portfolios
Our review of the evidence points us to using stocks for growth and bonds for preservation and volatility management. Stocks historically have posted significantly higher growth rates than bonds, so holding stocks for growth makes sense. Bonds historically have grown as well, just not as fast as stocks. Also, different types of bonds behave differently, as some bonds historically have moved in the same general direction as stocks, and some historically have moved in the opposite direction. Evaluating the trade-offs between the type of bonds we use in our portfolios is key.
Because we want the bonds in our portfolios to hold their value, or even go up in value when stocks fall, we need bonds that tend to move in the opposite direction of stocks. The type of bonds that meet this criterion are high-quality bonds and/or short- to intermediate-term bonds. High-quality bonds typically are issued by governments that have the ability to create money to repay them or by well-established companies that generate sufficient revenue and profits to service the debt. We tend to like short- to intermediate-term bonds because you get your money back sooner, allowing you to reinvest in better rates if they are available.
In the first quarter of 2020, when the global stock markets were falling on news of the COVID-19 pandemic, high-quality, short- to intermediate-term bonds did what we wanted them to do. They generally held their value and, in most cases, went up in value. This was a picture-perfect example of why we use these types of bonds. In fact, having money in assets that go up when stocks go down gives us the ability to rebalance, where we could potentially sell appreciated bonds and buy depreciated stocks. It also helps us avoid selling stocks at depressed prices to fund our lifestyle expenses.
As expected, not all bonds rose in value during the COVID-19 market decline of 2020. Investments like high-yield bonds, bank loans (also known as floating-rate notes), and lower-rated investment-grade bonds fell in value alongside stock prices. These types of investments became more popular with investors over the past decade as they sought higher interest rates from their bonds (which they had to take a lot more risk to get). Investors who pursued these bonds saw everything in their portfolio decline at the same time, likely quite a disappointing experience.
As we enter 2021, the interest we earn from our bonds is still very low. While this might tempt some investors to explore taking more risk with their bonds, we would urge you to recall that we use bonds to protect your financial life plan and to offset the ups and downs of stocks. Even with low interest rates, those benefits still exist.We remain proponents of having evidence to support each investment trade-off that we make in our portfolios. In the case of bonds, we feel the evidence still strongly supports the use of high-quality, short- to intermediate-term bonds. In a total portfolio, these types of bonds play a crucial role.