I advocate not to have bonds in a portfolio, but the conventional wisdom is to have a portfolio of stocks and bonds.
Let’s clarify a few points:
- Stocks are not more risky than bonds in any 10-20 years time period, they are just more volatile.
- Stocks produce a higher return than bonds.
If stocks are no riskier than bonds and if they give higher returns than bonds, why should anyone own bonds? Because they reduce volatility because with smaller ups and downs an investor is better able to withstand the changes in the market.
Let’s assume a portfolio of 50-50 stocks and bonds. Let’s assume that the expected return of stocks is 8% and the expected return of bonds is 2%. The expected return of your portfolio is 5%.
What I suggest is to put 100% of your portfolio in stocks. then draw a line that goes up at the rate of 5% per year. This means that if you start your portfolio with $100,000, by the end of the year you should have $105,000.
Here is an example of the Toronto Stock Exchange vs. a 6% growth line.
In this example, I overlap the real returns with the 6% growth line. If the returns are more than the 6% line, they are not to be considered are part of your assets, they are meant to be considered as insurance money, or protection against a downturn. Just like you don’t consider the money that you pay in insurance as part of your assets.
If the returns are less than the 6% line, then you just have to be patient and have faith that eventually the returns will catch up.
All that being said, you think you should own some bonds. At what stage should you add bonds to your portfolio?
Most financial advisers suggest adding bonds as a percentage of your assets as you grow older. They will say that if you are 60 years old, you should have (for example sake) 60% of your portfolio in bonds, and the older you get, the biggest the percentage of bonds you should have.
But let’s be realistic. If you only have $100,000 at age 60, you don’t have much money to protect and therefore, you should be more concerned with growing your portfolio than protecting it. On the other hand, if you have $5,000,000. You don’t care about making more money, you care about protecting your assets and you could easily be 100% in bonds.
The actual amount of money matter more than percentages.
So here is the question again: At what stage should you add bonds to your portfolio?
Answer: When you have reached your capital objective.
Let’s say that you believe that to retire you want to have $500,000 in your bank account. After years of hard work, you have reached the amount of $500,000. Then, the next step should be to start protecting your assets.
Let’s say that your portfolio of $500,000 grew 8% in one year. That would be $40,000. You would sell about $40,000 worth of stocks and buy some bonds. And do that for every year thereafter until you reach a level of dampening volatility which will make you feel good at night.
Disclaimer: Of course, this is my way of thinking which fits my risk profile. I am not saying you should do the same or that you should follow my example. You may have different risk tolerance or time frame.
The way that I think about it is that first you want to make your money and then you want to protect it. As you grow your assets you should keep in mind that there is a strategy to make your money, and there is another strategy to conserve your money. You don’t want to be too conservative if you have very little to protect and you don’t want to take risks if you don’t have to.
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