Here’s a follow-up to last week’s essay about reducing your risk with bonds. This week we’re going to cover how much you should have in bonds.
The 28 years I’ve spent working with the small investors have forced me to face an ugly truth…
In every sell-off, they panic-sell.
Thirty years of research from the financial behavior research firm DALBAR confirm the existence of this money-losing behavior. And despite decades of efforts to modify it, it’s not improving. In fact, it’s getting worse.
As we age and enter the realm of no more paychecks, the emotions that drive the “sell low” reaction to market shifts become increasingly acute. We panic-sell more aggressively and more readily.
Add to that our ability to track our holdings online second by second, which only adds gas to the fire. We have a super-volatile situation that will drive the current mountain of small-investor losses even higher. Those are losses we don’t have the time to replace.
The worst part of this scenario is that after we panic-sell – almost always at a loss – we are frozen in cash. In most cases, we sit in cash because we don’t know what to do or we’ve been scared into inaction.
No matter! In both cases, we’ve taken a beating in the market and are now losing money slowly to taxes and inflation.
The diversification/hedging solution the media and most of the financial planning community offers is the 60-40 rule. Lower your volatility – and hopefully your emotional reactions – by owning 60% stocks and 40% bonds or other lower-risk holdings (blue chip dividend payers, real estate investment trusts, etc.).
It’s a start, but it’s hardly the answer for the exploding number of boomers who are becoming increasingly risk averse the older they get.
My solution to the volatility-driven losses that retired persons cannot afford to incur is to own your age as the percentage of bonds in your portfolio.
For example, at age 55, 55% of your portfolio should be in some kind of bonds. At 65, 65% should be in lower-risk holdings and at 70, 70%.
As we age and become less risk tolerant, we should increase the portion of our investments that we don’t have to worry about in a sell-off: bonds.
Here’s a guide to how much bonds can reduce the risk and volatility in your portfolio. Treasurys have a 100% government guarantee of paying as promised. Tax-free, BBB- and higher rated municipal bonds return exactly as they promise more than 99% of the time. Investment-grade corporate bonds pay as promised 98% of the time.
Even high-yield bonds (the brats of the bond world) have a long-term success ratio of 94%. In today’s market, that number is up to 97%.
In addition to those success ratios, the fact that you are paid your interest every six months and get back $1,000 per bond in principal at maturity, no matter what the markets do, adds a level of security that we need at our age.
And as you age, increasing the number of bonds you own and the interest they pay establishes a minimum annual return for an increasing portion of your portfolio. I call it your base return.
The combination of the success ratios, the predictability of the interest and principal, and the base return will decrease your overall risk and stabilize your principal. That reduces the chance you’ll rely on emotion and sell at the bottom… again.
We make money only when we are in our bonds. The same holds true for stock.
We must decrease the volatility of our portfolios as we age and stop panic-selling… or get ready for a money ride few will survive.
Diversify and thrive!