Tag Archives: bonds

At what point should you start adding bonds to your portfolio

Preparing for winter

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:

  1. Stock are not more risky than bond in any 10-20 years time period, they are just more volatile.
  2. Stocks produce a higher return than bonds.

If stocks are not more risky than bonds and if they give higher return 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 of 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 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 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 in excess of 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 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.

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 asset.

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 dampen 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 an 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.

Now (and always) is the worse time to invest in bonds

With friends on a rainy day
With friends on a rainy day

Anytime anyone goes to a financial adviser two things happen:

  1. The financial adviser will only recommend their “in house” products — you know, the ones that have 2-3% management expense fees.
  2. They will ask you your age and they will miraculously show you a fund that is tailored made for all people your age.

We have already spoken about point #1 in previous posts. For sure, financial advisers will ALWAYS offer you the funds with high expense fees, because they get paid kickbacks, called trailer fees. Those kickbacks represent the major portion of their income. But guess what? Those trailer fees come out of your pocket. It is to the advantage of the financial adviser to always recommend the products which pay the best commissions for him/her. There are hundreds of low cost index funds and ETFs which financial adviser will never recommend, because even if those low cost index funds and ETFs are the best products for their clients, there is no commission involved. The investment adviser’s job depends on your ignorance.

On point #2, they are equally inept. The typical formula to choose a portfolio of stocks and bonds distributed like this: 100% stocks minus your age. That means that if you are 30 years old, you should have a portfolio of 70% in stocks and 30% in bonds. If you are 50 years old, you should have 50% in stocks and 50% in bonds, and so on. Really? the major contributing factor is our age? How about if I am already a millionaire? How about if I can hardly pay my rent? How about if I am good health? How about if I am in bad health? It doesn’t matter, he/she will simply look at the table his employer gives him and plunk you into the bracket recommended in their sales manual.

Historically, stocks have always been a better investment than bonds, but investing in bonds has always provided a false sense of security. In fact, what they provide is reduced volatility. We should not confuse less volatility with less risk. On the long run, bonds ARE NOT less risky than stocks, they are less volatile.

The reality is that the more bonds you have in your portfolio, the more you are handicapping your growth potential. Why would anyone slow down their money earning potential only because they are older? When you are older, when you need your money the most, it is precisely at that moment when you would like to get the most out of your money.

Here is another thing that is killing me. Sure, we all have heard that no one can predict the market and that a diversification between stocks and bonds is the prudent thing to do. But there is a moment in time when you can put rules of thumb to the side and use your common sense.

This part is a bit technical but this is how bonds work:

If interest rates goes down, the value of bonds goes up. If interest rates goes up, the value of your bonds goes down.

At this moment, August 2016, interest rates are at a record low. They are about 1%. If Interest rates don’t have much room to go down, then the value of your bonds don’t have much room to go up.

However, interest rates have a lot of room to go up. If interest rates go up, you will lose money. The potential to lose lots of money is very high.

Knowing this,why would anyone put any percentage of their hard earned money in bonds? Your probabilities of winning are low and your probabilities of losing are high. You are better off keeping your money under your mattress.


  1. Look for a fee only financial adviser.Don’t get a financial adviser who makes his/her living out of commission, he/she will only offer you the products which give him/her the highest commission.
  2. Don’t have any bonds in your portfolio, especially now but ideally never. Why would you shortchange your return. Even after retirement, you still would like to see your money to grow.

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Understanding The Bond Market

bondsOne of my readers, Natalia, asked me: “How does the bond market works?” If anyone else has a question about investing or personal finance, please write me a message.

Here is your answer, Natalia. Assume that one of your uncles wants to borrow from you $100 for one year and he is promising to pay you 10% interest. You agree to lend him the money. You give him the money and in return he gives you a piece of paper that he calls a “Bond” with a “Face Value” of $100 and a coupon (interest rate) of 10%.

Six months later, you need money and you want to sell your bond. While having dinner with your family you declare that you want to sell this Bond to anyone who is willing to buy it.

Let’s say that your sister wants to buy the bond, but 6 months have already passed, so you have earned 5% ( if one year is 10%, then 6 months is 5%), so you don’t want $100, you want at least $105. This additional $5 above the face value of the bond is called “a premium.”

Let’s change the scenario a bit. Let’s say that your uncle loses his job and he is having a hard time paying his bills. You become worried because you are afraid that he might not be able to pay you back. You offer the bond to your sister for $95. Your sister has confidence that your uncle will be able to pay his bond and she buys it from you. She is buying the bond for $5 less than what you paid for it, this difference in value is called “a discount.”

In the real bond market, companies, cities and governments need to borrow money all the time; they borrow money by selling bonds. Generally they sell all their bonds to one financial institution like the Royal Bank or to a consortium of financial institutions (Royal Bank, TD bank, BOM). This direct sell from the borrower to the financial institutions is called the primary market. Then the financial institutions sell the bonds to the general public, the general public is the secondary market. Once the bond is out on the secondary market, people buy those bonds from each other as if they were buying stocks.

There are many factors that determine the price of a bond, but two of the most important are risk and the interest rate.

Risk: If a company or a government has a good reputation, lets say Google, then people feel comfortable holding those bonds and would even pay more, but if a company is on the brink of bankruptcy, like Nortel, then the value of the bonds is lower, people will be willing to sell those bonds to someone else, even at a loss.

yieldsInterest rates: If the government increases interest rates, bond prices fall. Let’s say that the government increases interest rates from 2% to 5%. People will want to get rid of the bonds that were paying 2% to be able to buy the new bonds that are now paying 5%. They will be so desperate to sell the 2% bonds that they will sell them at a discount, and therefore driving the prices down.

The safest bonds are those issued by the federal government. If ever the government doesn’t collect enough tax dollars to pay back the bond holders, they can always go to their photocopy machine and print more money. Many people feel that with the escalating debt of the United States, one day people would not be willing to lend them money anymore. Their national debt is over 17 Trillions dollars. Canada’s debt is about $680 Billion.

When people invest in bonds, they get a lower return for their money than they would have gotten by investing in stocks, but bonds are a lot less volatile and its earnings more predictable. Many money managers recommend to have a portfolio composed of mostly stocks for younger people and a portfolio mostly of bonds for people close to their retirement.

I have grossly oversimplified the bond market. I have never traded in it and I don’t know anyone personally who has traded in it. Nevertheless, investing in the bond market is a fundamental part of personal finance and the economy and at the very least we should all understand how it works.