The stock market usually inspires more small talk and media attention than the bond market, but investors shouldn’t ignore bonds and other fixed-income investments. No matter what your age, investing experience or portfolio size, there is likely good reason to include some fixed income in your portfolio.
That’s because one way to mitigate risk in your portfolio is to diversify your assets. Diversification does not ensure a profit or guarantee against loss; its main purpose is to minimize the volatility in your portfolio. This straightforward strategy has many complex iterations, but at its root it’s simply about spreading your portfolio across several asset classes and sectors, including U.S. and foreign stocks, bonds, and short-term investments. Good diversification can reduce the risk and volatility in your portfolio, ideally allowing you to achieve returns with less stomach-churning ups and downs along the way.
A diversified portfolio generally has its investments divided over four asset classes:
Stocks represent the most aggressive portion of your portfolio. Stocks provide the opportunity for higher growth over the long-term. But this greater potential reward carries a greater risk, particularly in the short-term, because market volatility may mean your investment is worth less when you sell it.
Bonds generally provide regular income and less volatility than stocks, and can act as a cushion against the unpredictable ups and downs of the stock market. Often, bonds do not move in the same direction as stocks, although prices of certain categories of bonds, such as lower quality corporate bonds, are more correlated with stock prices. Investors who are more concerned about safety rather than growth often allocate more of their portfolio toward Treasury or other high-quality bonds rather than stocks. That safety has a price, though: Many bonds, especially high-quality bonds, won’t offer returns as high as stocks over the long term.
Short-term investments include money market funds and short-term certificates of deposit (CDs). Money market funds are conservative investments that offer easy access to your money and stability of principal. Their goal is to preserve the value of your investment at $1 per share, but in exchange for that safety, money market funds usually have lower returns than bond funds or individual bonds. While money market funds are considered safe and conservative, however, they are not insured or guaranteed by the Federal Deposit Insurance Corporation (FDIC) the way most CDs are.
International stocks and bonds often perform differently than their U.S. counterparts, and provide exposure to parts of the world not represented by U.S. fixed income securities. If you’re thinking like a global investor and have a healthy appetite for risk, consider some allocation to foreign stocks. The U.S. stock market, though huge, represents roughly just half the global stock market.
A mix of these asset classes can help you construct a portfolio that has fewer extreme swings than a non-diversified one. The pie charts below represent portfolios with different allocations for different risk profiles. The average annual return for each portfolio (from 1926 through 2011, including reinvested dividends and other earnings) is noted for each portfolio, as is the highest and lowest one-year returns. The most aggressive portfolio, made up of 70% U.S. stocks and 30% international stocks, had an average annual return of 10%. However, it was also the most volatile of the portfolios. Its highest one-year return veered from a high of just under 163% to a loss of nearly 68%. Adding a little fixed income to the portfolio, however, lessens the range of those swings without giving up too much over the long haul: By adding a 5% allocation to short-term investments and 25% to bonds and lessening the stock allocation to 49% and international to 21%, the portfolio would have returned almost 9% over the same period, with lower extremes on the high and low end. The more fixed income you add, the lower your portfolio’s volatility generally is, but you’ll also probably give up a little return.
Your investing timetable
People are often accustomed to thinking about their savings in terms of what they’re saving for—retirement, college, a down payment or even a vacation. But the what isn’t as important as the when. How you allocate your investments across stocks, bonds, and short-term investments should be a function of when you’ll need the money.
In general, the amount of time you have until your goal will help determine your risk tolerance, which affects your asset allocation. For an investor who has a longer time horizon and is willing to take on additional risk in pursuit of long-term growth, a higher allocation in stocks may be appropriate. Investors with a long time horizon but are more risk-averse may opt for a more balanced portfolio. Even the most aggressive asset allocation model, however, should consider a fixed income component to help reduce the overall volatility of the portfolio.
As you get closer to your goal—or if your goal is five to 10 years in the future when you begin saving—you may want to shift your investments into more conservative securities, like fixed income mutual funds (instead of stock funds) or certain individual bonds such as short term Treasury securities. Adding more conservative fixed income investments to a portfolio can help to modulate the ups and downs found in equity investments, a key factor when you’re expecting to need the money soon.
In retirement, a good portion of your portfolio should be in stable, income-producing investments, but just like few portfolios should be 100% in stocks, few should be 100% in bonds. Even retirees will need a certain amount of growth-oriented investments to combat inflation and, especially for younger retirees, invest for growth over what could be a decades-long retirement.
Regardless of the asset allocation model that you choose, a diversified portfolio can help you achieve success in meeting your future goals. A well thought-out plan is critical: Your money is too important to invest without a plan.