FREE NEWSLETTER
WE WANT OUR STOCKS to behave like bonds, and our bonds to behave like cash investments. That leads to all kinds of portfolio contortions—some of them damaging to our investment results.
Remember, risk is the price we pay to earn higher returns. Many folks want those higher returns, but they’re anxious to avoid risk. Chalk it up to loss aversion: We get far more pain from losses than pleasure from gains.
Result? Think about stock-market strategies like purchasing equity-indexed annuities and writing covered call options. Equity-indexed annuities capture part of the market’s upside while guaranteeing against losses—assuming the buyer owns the annuity for long enough. Meanwhile, writing call options allows folks to collect extra income in the form of option premiums, providing a small buffer against market declines, but the price is a cap on potential stock-market gains.
As investors look to limit losses, however, the biggest portfolio contortions tend to revolve around bonds, not stocks. The strategies employed typically involve favoring individual bonds over bond funds, and then holding those bonds to maturity. This can add a fair amount of complexity, especially if folks build elaborate bond ladders, with each rung designed to cover a particular year’s spending.
No doubt about it, there’s some reward for this complexity. If we buy an individual bond and hold it until it matures, we know exactly how much interest we’ll receive each year and how much we’ll get back upon maturity. Sound appealing? My advice: Before buying into the notion that bond funds are riskier than individual bonds, and that holding individual bonds to maturity eliminates risk, we should ask ourselves four questions:
To be sure, the risk of individual securities is reduced if we stick with Treasury bonds, which most experts believe carry scant risk of default. Worried about inflation? That can be addressed with inflation-indexed Treasurys and Series I savings bonds.
Still, I’ve never owned an individual bond, except a $75 EE savings bond I won for finishing second in a 5k road race. Why not? I’m not that concerned that my bond funds might be worth a few percent more or less than I’d hoped when it’s time to cash out. Why would I? Heck, I’ve lived through two 50%-plus stock market declines during my investing career, so modest fluctuations in bond prices hardly seem worth the worry.
Meanwhile, I simply don’t want the hassle and complexity of dealing with individual bonds, including Treasurys and savings bonds, and I sure don’t want to bequeath that sort of portfolio to my family. Given all the complaints I’ve read about dealing with TreasuryDirect, and especially cashing in Series I and EE savings bonds, I’m glad I made that choice.
But many readers, I know, strongly disagree.
Jonathan Clements is the founder and editor of HumbleDollar. Follow him on X @ClementsMoney and on Facebook, and check out his earlier posts.
Want to receive our weekly newsletter? Sign up now. How about our daily alert about the site's latest posts? Join the list.
What kind of race gives out EE bonds as a prize? Talk about a sexy marketing ploy!
I too have never owned a bond, until one year ago when I put half my fixed income holdings into a 5-year TIPS at the auction via Vanguard.
That timing was smart (er, lucky); needless to say I’m pretty much a happy camper. Pretty much zero risk, absent TEOTWAWKI.
ETA: I’m of an age at which I now keep enough in fixed income to (along with SS) cover all expenses until The End. It’s a “Bonds are for me, equities for my survivors” strategy.
Having just looked at my portfolio YTD with the 1st Qtr in the books, I see that I have;
SPY (S&P 500 ETF) -5.19% (60% Portfolio)
BND (Intermediate Bond ETF) 1.79% (20% Portfolio)
VEU (international Equity ETF) 6.29% (15% Portfolio)
Cash 4% Annually (5% of Portfolio)
For the last couple of years, I have wondered if having everything in equities would make me better off. Given the current environment, I sleep better with some diversification that seems to work to help balance it all out. Not sure there are any perfect answers – just ones that I can sleep with at night.
I’d like to see more discussion of managing risk as opposed to minimizing or eliminating risk. As someone once said, the sluggard turns over in bed and says, “There are lions out there.”
I periodically look at the small part of my portfolio in bonds and I see how poorly they perform against my stocks, and I ask myself “Am I a sucker? Why do I put my money here to earn 4%, and that is before taxes and inflation?” Why should I even care about looking at alternative bond funds if all they do is vary by tenths (or even hundredths) of a point? But I still keep that small holdout of bonds in the same bond funds (even though I also have a decent pot of cash.) So, I ask readers – Am I a sucker in this day and age?
Do you follow the math or is this a more emotional question?
To me, bonds and cash are there to provide spending money if it’s a bad time to sell stocks. If you hold more than is necessary to cover five to seven years of spending needs, you’re likely doing it to reduce portfolio volatility. Holding more in bonds and cash than is needed for those two goals? Perhaps you have indeed allocated too much to bonds and cash.
I would add one thing here:
It’s better to own ETF’s for tax reasons than mutual funds. You’re not vulnerable to forced liquidations of fund holdings, that can trigger cap gains which are usually better done on your terms (not the markets)
Then on top of that, there’s the added expense of transactions in bond funds, both larger spreads and higher transaction costs, mean that forced redemptions can mean taking a permanent bite out of the total return.
Equities have similar concerns, but the nature of the equities markets mean the transaction costs (and ERs) are lower such that it’s not as big a concern.