What is the Role of Bonds in Your Portfolio?

A lot of the time, investors view each of their investments in isolation. They focus on how this fund or that fund did. But this is a fundamentally wrong headed approach. Just like your investment portfolio only really matters – and can only be evaluated – in the context of your overall retirement plan, you need to look at the different pieces of your investment portfolio in the context of your overall portfolio.

But that said, we can talk about the roles that different types of investments play within your overall portfolio (and plan). Bonds are often thought of as the boring part of your portfolio. And that is exactly right – and also why bonds are both so powerful and versatile (and interesting). Because we know what the cash flows from a bond are going to be, we have a decent understanding of what they will do in the future (certainly a lot better than we do for stocks anyway).

Like everything else, the specifics of how you use bonds will come down to what you are looking to do with them. If you are looking to generate reliable income from your bonds, you’ll likely want to be holding individual bonds to maturity in some sort of bond ladder. But here we’re going to be focusing on bonds as part of your investment portfolio.

So let’s dive in.

Bonds in Your Investment Portfolio

Anytime we talk about investing, we need to start with the fundamental tension in the financial markets. Risk and return are related. Getting higher returns means taking on more risk.

And bonds definitely fall in line with this principle. Bonds (as a group) have both lower levels of risk, and a lower expected return than stocks (as a group). Since, assuming the bond doesn’t default, we know all of the payments the bond will send out, the only real uncertainty in how much the bond is worth (and how that price will change through time) is how valuable those payments are now (and how that might change as interest rates change).

The upshot is that you can think of bonds as the ballast of your portfolio. They are the stabilizers of your portfolio – they don’t let the wild and crazy stocks push your portfolio all over the place.

This is the thing about bonds in a portfolio context: they’re about managing risk, not about hitting it big. You include bonds not for the thrill of the chase, but because they are boring. And because they are boring, they allow the other pieces of your portfolio a solid base to work off.

What Sort of Bonds Should You Use?

This leaves a pretty big question though – what bonds do you want to actually use in your portfolio?

There are a lot of different types of bonds out there. And the ones that you include in your portfolio are really going to depend on the specific goals you have for your portfolio. But you’ll generally want to focus on minimizing the amount of risk that you take with your bonds.

And we can see why this is pretty clearly when we start looking at the historical data.

A good way to look at this is by looking at the fundamental risk factors available to investors. For our purposes, there are three primary stock risk factors:

• The Equity Premium – the returns of stocks minus the returns of very short term Treasury Bills. This is looking at the returns investors get just for being in the stock market.
• The Size Premium – the returns of small stocks minus the returns of large stocks.
• The Value Premium – the returns of value stocks minus growth stocks.

And on the bond side we have two main risk factors:

• The Term (or Maturity) Premium – the returns of long term Treasury Bonds minus the returns of short term Treasury Bills.
• The Credit Premium – the returns of Corporate bonds minus the returns of Treasury Bonds.

(You can find people telling all sorts of other stories, but you can tease out of if a risk factor is real or not).

When we look at the underlying data the story is pretty clear

We can be more precise if we want to, but the simple average return per unit of standard deviation tells the story pretty effectively. It doesn’t make sense to take your risk with your bonds. You get paid more for taking risk on the stock side of your portfolio.

Because of this, absent other considerations, you’ll generally want to stick with short term and high quality bonds in your portfolio. (And this is even ignoring that income investing just doesn’t make sense).

The purpose of incorporating bonds into your investment portfolio isn’t to directly generate substantial income or returns. Instead, they allow you to set the overall level of risk in your investment portfolio and give your more volatile stocks and assets the breathing room they need to do their job effectively.

Think of it in terms of music. Your stocks are the brass section, loud, exciting, and capable of reaching thrilling crescendos. Your bonds are the percussion, the reliable beat that keeps the orchestra on tempo. Played together, they create harmonious growth in your investment symphony.

Understanding the role of bonds in your investment strategy is akin to understanding the purpose of each instrument in an orchestra. Each has its own sound and should be played in unison with the others for the most beautiful results.

And while the music of your investments can sometimes strike a dissonant note, ensuring that your bond investments are aligned with your long-term goals will always lead to a portfolio that sounds right for you.

Remember, the true value of bonds in your portfolio lies not in their current performance, but in their ability to maintain the delicate balance between risk and return as you dance through the stages of your financial life.

To find out more about how to build an investment portfolio that works for you, read our eBook 9 Principles of Intelligent Investors.