Bonds to Reduce Volatility

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During the first ten years of my investing career, my asset allocation was solely invested in stocks.  From 1997 until 2007, my portfolio returned 8.5%.  I wrote about that period in my first post of this series 100 Percent Invested in Stocks.  In this post, I will write about how adding bonds to my portfolio reduced volatility during the decade that followed.

By the year 2007, my portfolio had five years of positive returns.  At that time, I was reading a good amount of Jack Bogle’s writings on asset allocation.  He suggested holding (100 – your age) in stocks.

After investing for 10 years, it made sense for me to reduce the volatility of my portfolio.  However, I still was focused on aggressive growth because I had the goal of retiring early.  I felt an asset allocation equal to my age in bonds was too conservative.

Another factor that I had to consider was that I was newly married.  Prior to getting married, my wife and I decided to manage all our finances together.  We sat down and evaluated how we wanted to invest our money after we were married.

At that point, I was 30 years old and my wife was 37.  We decided on adding 25% of our portfolio to bonds.  It was close to equaling (110 – our average age) in stocks.

This is how our new asset allocation looked:

S&P 500 Fund – 43%

Extended Market Index Fund – 13%

Total International Stock Market Index Fund – 19%

Total Bond Market Index Fund – 25%

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My second decade as an investor was equally as volatile as my first decade. In 2007, our portfolio was off to a solid start by returning over 10%.  Then 2008 came.  That was the beginning of the great recession that resulted from the subprime mortgage bubble bursting.  In 2008, our portfolio had a loss of more than -30%.  If I had my original asset allocation of 100% invested in stocks, we would have lost more than -40%.

Just as during the dot.com bubble and the three years of negative returns that followed, we just kept investing and moving forward.  We stuck to our normal schedule of dollar cost averaging.  We also stuck to our plan of semi-annual rebalancing.

Fortunately, the market bottomed out in March of 2009 and one of the greatest bull markets began.  By the middle of 2010, we had recovered all of our losses. From 2009 to 2016, our portfolio averaged over 10.5% annually.

That 10.5% return did not occur without volatility.  During this period, there were peaks and valleys along the way.  There were budget crises, polarizing politics, debt-ceiling debacles, federal government shutdowns, and threats of austerity.

Over the course of those ten years, our portfolio had an average return of 5.24%.  If we were invested in 100% stocks the average return would have only been 5.58%.  By adding 25% in bonds, there was almost zero impact on growth.  The bonds did help to reduce volatility.

If you are not comfortable with having 100% of your portfolio invested in stocks, consider adding some bonds to your allocation.  Bonds are susceptible to interest rate increases, currently have low yields, and do not hold up as well as stocks during periods of inflation. Bonds do, however, reduce volatility when the stock market is in decline.  That is the main reason why they have an important role in our asset allocation.

Please keep an eye out for Part-3 in my series on asset allocation.  In Part-3, I will write about the balanced-growth asset allocation that we will hold until we reach early retirement (FIRE).

Please remember to check with a financial professional before you ever buy an investment and to read my Disclaimer page.

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4 thoughts on “Bonds to Reduce Volatility

  1. Save Splurge Deny Debt - Cameron

    Interesting read. As a young person with high risk tolerance I am completely invested in stocks now, as bonds are pretty junk to me right now at these levels.

    I do think being a former investment professional and analyst that I overthink this. A lot of people should have some sort of bond allocation for protection and a lot of time peace of mind. Interesting to listen to other points of view on this topic!

    Reply
    1. thefinancialjourneyman Post author

      Thanks for your comment.

      At this point, I don’t see bonds as a growth vehicle.

      I use them to just offset the risks of my stock allocation.

      If there is a large stock market correction, I will use the money I have in bonds to reallocate to my target allocation.

      Being young, holding most of your portfolio in stocks makes sense.

      Reply
  2. Troy @ market history

    I think bonds are a terrible investment right now. Interest rates around the world are going up. Why would you want to buy a 3% bond today when you can buy a 5% or 6% bond in just a few years ? Inflation is picking up an interest rates are going higher as central banks around the world start to hike rate

    Reply
    1. thefinancialjourneyman Post author

      Thanks for the comment.

      You have a good point and I will have to take that into consideration.

      Maybe I should add some short-term bonds and TIPS to my fixed allocation.

      I keep bonds to reduce volatility and to buy low when there is a market correction.

      Reply

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