By Dr. Anna McKeone, Guest Writer
Even for early- and mid-career investors, most respected asset allocations recommend holding bonds. This recommendation is based on the idea that bonds do not fluctuate as much as stocks, and it's to the point where people think of them as fairly “safe” money. In addition, they can (but not always) be negatively correlated to stocks—meaning that if stocks are down, then your bonds may be worth more during that same time period.
But for some of us, bonds may not make sense. Here is why I have exactly 0% bonds in my portfolio.
Trading Education for Time in the Market
Like most of you in the medical field, by the time I started investing, I already had some gray hair. Because of the late start (and with little assets to lose), I was willing to go all-in on stocks to take more risk for better expected returns long term. Many of us have friends that had been contributing to their retirement accounts for a decade by the time we started making money as attendings. The power of compounding is the real deal, and in order to make up for that lost time, you either need to save more yearly toward retirement, take more risk for better expected returns, or both. I have chosen to hold 90% stocks and 10% real estate with no allocation to bonds, partly because of my late start and because I feel I need to be willing to take more risk to catch up from my decade of time in higher education when I wasn't in the market.
Long Investment Horizon
I am on my own bumpy road to financial independence, and my road is a long one. Having a long investment horizon allows me to invest in riskier assets because the expectation is that over the long run, they will get me to my destination faster by providing better returns. The riskiest time for retirees is the few years before and after retirement when the sequence of returns risk will be most impactful.
Most investors will want to significantly de-risk their portfolio with something like a bond tent in the years around retirement to mitigate that risk. As I am still quite a way from retirement, I get to celebrate when stocks are down because to me, they are just on sale (I also celebrate when stocks are up and I am making money on my money).
In the last few years with great returns, this has been pretty easy to stomach. And then came 2022 with negative returns. Although watching my retirement account numbers go down instead of up is painful, I know that unless I pull that money out, the loss is just theoretical. Plus, I would still rather lose 10% on my money this year but have had that same money making 25% yearly over the last few years. If I had not had it in stocks during that time, there would have been much less total in the account to date. In addition, I will not need that money for 20 years and feel confident that by the time I need it, that money will have come back and made more.
Fungibility of Debt
But the biggest reason that bonds are a no-go for me right now is that money is fungible. If money is fungible and debt is money, then that means that debt is fungible, too. I currently still have low-interest debt, including my student loans and mortgage, that I am working to pay off. Initially, when I was setting up my written investment statement, I had planned to have a bond allocation. However, as I analyzed my financial situation more closely, investing for a 3% not guaranteed return while I had 3% debt did not make sense. The idea of investing in a bond with money that is essentially borrowed from my house or student loans felt wrong.
I realized my low-interest debt is essentially functioning as a negative bond. By paying off my low-interest debt instead of investing in bonds, I am guaranteeing that return. Some would say, “Leverage all the low-interest debt you can!” And those people I would direct to Dr. Jim Dahle’s excellent lecture on debt at the Physician Wellness and Financial Literacy Conference (you can find that lecture in the Continuing Financial Education 2022 course). Taking the percentage of your asset allocation that would normally be assigned to bonds and using that money to pay off your low-interest debt will have the effect of increasing your net worth while making steps toward a debt-free life.
Have a Cushion
To do this responsibly, I need easy access to money if something happens to me and the market is down. This includes having an adequate emergency fund as well as access to credit cards and a home equity line of credit if things really go south. My plan is that once my low-interest debt is paid off, I will use that money, at my target asset allocation, toward bonds as typically recommended.
When Will Bonds Be Right for Me?
I see adding bonds when I have my debt paid off. I will even pay off my house first, as I am debt averse and love the idea of owing nothing to anyone. Once I no longer have debt payments, I will add an allocation to bonds, probably somewhere around 25%. Then, as I am approaching retirement, I plan to create a bond tent for the 4-5 years before and after retirement when the sequence of returns risk is highest. A bond tent effectively increases allocation to bonds in the years leading up to retirement, and I will likely target up to 75% at that time. In the years following retirement, I plan to taper back down to around 40% bonds. If all goes as planned and my retirement fund remains adequate, I will again start increasing asset allocation to stocks. The more legacy money I have can then be directed toward more giving.
As they say, personal finance is personal. No matter what you choose to do with your investments and debt, make sure you understand it, that it is part of your written investment statement, and that it allows you to sleep well at night.
What percentage of your portfolio is in bonds? Do you think it makes sense to have absolutely zero bonds in your possession? Has the cratering market of 2022 changed your opinion? Comment below!
[Editor's Note: Dr. Anna McKeone is a practicing emergency physician and a lover of the outdoors and personal finance. You can find more of her work at The Bumpy Road to FI. This article was submitted and approved according to our Guest Post Policy. We have no financial relationship.]
I confess. I have owned a few EE Savings bonds over the years. Late last year and in January, my husband and I each bought some I bonds. Other than that $40k in I bonds, although we are both in our late 60’s and retired, we do not own bonds or bond funds.
Why don’t we own any significant amount of bonds? Answer is passive income. We both have pensions from our work with the New York state civil service. The NYSLRS pension fund is extremely well funded. Our income from Social Security, because it is Cost Of Living Adjusted, is growing. We’ll get a bump in passive income when I take Social Security based on my own earnings at age 70. This passive income from the New York State and Federal governments is very secure. That passive income takes the place of the stable/secure income being secured by bonds.
I love that perspective. I really enjoy seeing how people mitigate financial risk in their portfolios while still trying to maximize their returns as well.
How big is your emergency fund?
A common phrase I read on finance forums is “I’m 100% stocks. But that’s separate from my $300,000 cash emergency fund that I don’t include in my portfolio”.
Good question. First of all, the way I am paid I get a trail out over a few months even after I stop working, much smaller paychecks but still something. My emergency fund is approximately three months living expenses. My only debts are a reasonable house payment and $600 a month student loan payment so I don’t have tons of required payments which is really nice. As I’ve gotten older, I feel like I need to beef up my efund a little more. And will be working on that this year. Always a work in progress….
Other thing I should mention and could have included in the article is adequate insurance. The foundation for any financial house even before emergency fund should be adequate disability, life, home, malpractice, umbrella insurance etc. This will allow for more risk taking in investments as well
Try this spreadsheet exercise: include the amount of your emergency fund in the bond/cash side of your total portfolio. If you never touch it, or refill it if accessed, this is the eventual resting place in your retirement portfolio. Allows you to feel more comfortable being more aggressive with your remaining assets.
I like that, thank you
Hi Dr. McKeone,
Could you please share your asset allocation?
Thanks!
Maha
All index funds
60% large cap
20% small cap
20% international
Thanks!
How does that break down between value and growth? Are they Vanguard funds? If so, could you share the ticker symbols?
Yes, 100% Stocks work if you can stand the tracking error. I am assuming you have read Meir Statman and Morgan Housel.
Not having to pay a thing (such as your mortgage) is the same as making more tax money. It does make sense to not have bonds when you have a big fixed rate mortgage. I read something once that a 80/20 S/B portfolio had much less volatility, but similar returns to a 100% Stock portfolio.
I am also curious about your asset allocation.
Don’t lose your job.
Wrong tense. 100% stocks has worked. So far a 100% stock portfolio has worked well. No guarantee that will happen in the future, and that’s assuming you can handle it in a nasty bear.
Agreed 80/20 is very reasonable. Just pushing people to think outside the box and know what they are doing and why they are doing it. I love the way we all challenge and encourage each other in this group!
My big beef with the 100% stocks argument is “Why stop there?” If 100% stocks is good, why isn’t 120% better? Margin loans make it easy in a taxable account, but you could even do it with student loans or a mortgage. The math will make it look better and the risk of a margin call at 120% is awfully low.
I am on the debt averse side now after starting -900 K in debt with nothing to my name. Didn’t sleep well at night with that one. Will continue to pay off low interest debt rather than leverage-just my comfort zone. Plus I listened to a great lecture this year at physician wellness and financial literacy conference that encouraged me to be debt averse even more 😉
So what you’re saying is you’ve cut back to 100% stocks!
I’ve been retired six years and basically have a 55/45 stock to bonds and cash portfolio. But when I was in accumulation mode, as you are, I was zero bonds and nearly 100% stock funds. I only switched to a balanced allocation after I was well past FI. I don’t think you need bonds until you are starting to live off your assets, and maybe not then even.
There is the school thought that once you’ve won the game stop playing, but then there is the other school of thought that once you have more than enough grow it and give it.
My principal reason for not investing in bonds now is the fact that the bond market has been on a bull market joy ride for forty years as interest rates have fallen. There is a hard rail limiting this bull market which is a 0% interest rate. Hence the odds are overwhelming supporting flat or rising interest rates in the coming years, as we are currently experiencing. The bond market is guaranteed to fall when interest rates rise, so buying bonds is not a smart thing to do now. If you buy short term bonds to minimize your risk, your return will be horrible. If you buy long-term bonds, you will be stuck with a relatively low interest rate because you won’t be able to sell the bonds after interest rates rise, without losing your shirt. For reference, this website has a graph of 200 years of the 10-year Treasury yield: https://advisor.visualcapitalist.com/us-interest-rates/
People have been saying the bond market is “guaranteed to fall” because “interest rates must rise” for the last 14 years (and maybe even before then). It only JUST happened in the last 6 months. It’s entirely possible all of the rise in bond interest rates has already happened. You make your bets and you take your chances. But if you have decided you won’t buy bonds until 10 year treasuries yield 10%+ again, you may never buy them because yields may stabilize around 3%, 5%, or 7%.
It is a simple probability game. The closer interest rates get to zero the higher the probability going forward that bonds will underperform. You imply that never buying 10-year treasury bonds would be a tragedy. I disagree. I think it is better to mitigate risk by diversifying into a wide set of assets that each have a high probability of an excellent long-term return, than to add assets which have a low-probability of good long-term returns, even if they add diversification.
Not sure I’m saying it’s a “tragedy”, but I’d love to hear what assets you think have a high probability of an “excellent” long term return and how you define excellent. My crystal ball always seems to be so cloudy. Diversification, including into bonds, protects you from what I don’t know. And when it comes to the future, there’s a lot I don’t know.
I recently have read an article that stated that a researcher concluded that a combination of stocks and annuities had some of the best rates of returns and that buying annuities in stages instead of one lump sum helped build up your income gradually. Also, it is interesting to look at the effects of higher dividend paying stock but beware of value traps. Maybe a smaller but growing divendend yielding stock like MSFT will increase dividends YOY. Corporate stock buybacks also increase the value as long as there is enough free cash available, etc.
I think a good case can be made for using SPIAS to spend down principal in retirement, from a mathematical, risk, and behavioral standpoint. More information here:
https://www.whitecoatinvestor.com/spia-the-good-annuity/
But I wouldn’t go the dividend stock route. Dividend stocks are not bonds.
https://www.whitecoatinvestor.com/substituting-dividend-stocks-for-bonds-friday-qa/
60 % Municipal Bonds . 40% index funds and cash. Munis pay me $8000 per month tax free. Sleep like a baby
The average bear market -10 months
Sorry. I meant to say That the average bear market lasts roughly 10 months. The longest beer market since 1928 lasted a whopping 21 months. And I mean that sarcastically. So just stay the course. Honestly bonds are A lost cause in this environment.
Once you get yields up to eight or 10% that’s when I would start thinking about bonds. I do have 5% of my net worth in I bonds which I max out every year as well as Municipal bonds in my taxable portfolio But the Lion share of my net worth is mostly centered around VTI, 25% VOO 20%, VNQ,15% VBR 10% VBK 10% VIAX 15%
Why 20% VOO when you already have 25% in VTI? You know the correlation between the returns of those two ETFs is like 0.99, right? Especially when you’re trying to get a small tilt too with VBR and VBK. Seems like lots of room there to simplify. First, figure out if you want a small or a large tilt. Then just add that to TSM. Perhaps something like 50% VTI, 20% VB, and 15% VNQ.
Perhaps using VTI or VOO as a tax loss harvesting partner?
Perhaps, but I wouldn’t consider those separate allocations if so. I don’t have an allocation to VTI and ITOT even though I won both. I have an allocation to US stocks or Total Stock Market.
Of course, we always need to clarify from which perspective we are approaching the issue: as a now older physician who looks to bonds to provide income, rising interest rates are something I embrace. I was much more aggressive in my stock percentage when I was younger and held only a small portion of bonds. I always thought the old adage of “100 – your age in bonds” was ridiculous but I find myself drifting towards it now (although I have substituted some mildly more aggressive real estate debt investments for a portion of bond allocation).
Advisor got me into this balanced fund from an inheritance. I never wanted bonds. Have 50% annuity and cash, 50% index funds. I want out of bonds. They make nothing and have fallen dramatically in 6 mos. I appreciate your point that rise in rates has already happened. Should I take the loss now or hold…..tax rate is my issue but could take out n keep in IRA as cash and take out in RMD as required. Can they make back this loss in the next few years? And yes I Bonds and savings bond have been a great part of portfolio.
So you want out of bonds AFTER they fall in value? Are you sure? Seems a good time to stay the course but of course they could continue to go down for a while. No guarantee.
What are your overall financial goals? What does your written financial plan say? Jumping in and out of bonds or stocks or real estate based on how they are doing is what will get you into trouble. Look at your risk tolerance, look at the rest of the risks you are taking with debt, leverage or risky investments. If looking at all that indicates that you should hold bonds then hold them for the long term. Maybe you just need a smaller allocation toward them to find the right balance to for you.
Here’s my analysis of where we are plus a bit of crystal ball: Too many dollars (printing money) chasing too few goods and services (COVID, supply chain, Ukraine/Russia conflict disruptions) equal rising cost of goods and services–i.e. inflation. Then self-fulfilling prophecies by consumers and producers and continued inflation positive cycle. Then Fed has to raise interest rates aggressively (no soft landing) to put a thumb on it with a major cooling of the economy (stagflation). Interest rates will increase until inflation comes back down (bad for bonds). This will likely cause a recession that will be slow to recover from.
Uhhh….there are precious little specifics there. Your crystal ball seems just as cloudy as mine. There’s nothing actionable there such as how high inflation will go, when it will come down, how high interest rates will go etc. You can’t use vague sentiments like that to drive an effective investment plan.
I guess my feeling is there is always going to be something: pandemics, wars, elections and crazy Rich people shooting things into space. I am not spending my time predicting whether or not the market is going up or down because of it as that has already been proven to not be predictable. Make a plan you are comfortable with, can sleep with at night and stick with it.
Bonds are fixed income. And fixed income has the property of certainty: you know exactly when and how much cash flow you’ll be getting. But quite rightly, there is a cost to that certainty. If you don’t need the certainty, do you need bonds? For myself, that certainty is useful to manage risk, as I can hedge out the risk of known liabilities. Other than that, I don’t see a role for them.
Also, the vast majority of fixed income is nominal fixed income. But most of my known liabilities are real liabilities. So hedging out the risk of known real liabilities with nominal fixed income may not work well, especially in the long term. But in the short term, nominal fixed income is probably good enough to meet known real liabilties.
There are several tools I use to manage risk. I insure against the risk of several known unlikely financial catastrophes. I use cash equivalents (emergency fund) to hedge out the risk of unknown liabilities. And I use bonds to hedge out the risk of known liabilities, usually short term ones.
I don’t consider any of what I mentioned in the last paragraph as investments. I don’t expect to make money from them on a real aftertax basis. But they enable me to keep the compounding going on my investments.
Some compare investing to a marathon. There is some truth to that, but I like to consider investing as 26 one mile races. To go on to the next one mile race, you have to finish to previous race. If you run into problems in the previous race, that may delay the start of the next race or force you back to a previous race. In the worst case scenario, you have to start again.
Insurance, cash equivalents and bonds decrease the risk of having problems in any one of those one mile races.
The topic of leverage has been raised. Leverage is more than just going short fixed income, as opposed to going long fixed income with bonds. With leverage, there is the possibility of permanent loss and even bankruptcy, which doesn’t exist going long fixed income. With leverage, the risk of having problems in any one of those one mile races increases.
I like that 26 one mile race analogy.
For the sake of completeness, I should mention that home ownership minus mortgage is another common way to manage risk. Except for maintenance, taxes and utilities, homeownership hedges out shelter costs. This assumes that you own the home long enough that the transaction costs and the price risk of home ownership is less of an issue.
There are some very useful graphs and argument from Larry Swedroe about including at least some bonds in your asset allocation to maximize overall returns when rebalancing. It seems somewhat counterintuitive that you could have higher return with less risk, but that’s the whole point of calculating efficient frontiers – to maximize return and minimize risk. After reading Swedroe, Bernstein, and Ferri, we went from 100% stocks to 90/10 (with 80/20 likely better, but 90/10 was a compromise).
With rebalancing, a 90/10 portfolio can get very close to the return of a 100 portfolio and with decreased volatility.
However, such graphs ignore costs. There are costs to rebalancing. That includes your time, bid ask spreads and commissions.
But the 800 pound gorilla of costs is taxes. With rebalancing, cap gains tax will have to be paid. And taxes on bonds are often higher than stocks.
IIRC, William Bernstein advices against rebalancing in a taxable account, other than with income from the underlying investments and new contributions to the portfolio.
Another assumption of those graphs is that volatility is risk. All investors face risks, and volatility is one of them. The relative importance of volatility among those risks varies among investors. At least for myself, other risks are much more important than volatility. To make money in investing, I have to accept certain risks that are rewarded with premiums. And those risks come with volatility.
Nonsense. I’ve been rebalancing for nearly twenty years. I’ve yet to realize a capital gain to do so. And capital gains taxes on bonds, if they had to be realized, would be lower than capital gains taxes on stocks because they don’t increase in value as much if at all.
My comment that “With rebalancing, cap gains tax will have to be paid” is wrong. It would be more accurate to state that “With rebalancing, cap gains tax may have to be paid”. By rebalancing using income from the portfolio, new money coming in to the portfolio and the use of nontaxable accounts, it may very well be possible to not pay cap gains tax on rebalancing. My point would be that if you have to pay cap gains tax in order to rebalance, rebalancing becomes debatable in its importance.
And I would agree that cap gains tax on bonds is usually much less than on stocks. But that doesn’t change the possibility that bonds may be less tax friendly than stocks. I would emphasize that it’s difficult to make strong statements about taxes, as taxes vary with jurisdiction and time.
I agree with that. Your threshhold to rebalance should be a lot higher if it requires capital gains taxes to be paid.
If one is investing in bonds in taxable, the usual route is muni bonds, which are very tax friendly.
Reducing the portfolios volatility is actually what improves the returns. It’s a bit complicated mathematically, but you can think of the what similarly to if you lose 50% of your portfolio’s value, you need a gain of 100% to be back to baseline, so if you only lose 25% of the value, you’d only need a 50% increase to be back to baseline. More volatile assets tend to be more risky with higher expected returns, but the volatility itself isn’t what leads to the higher expected return.
You’re making the case that rebalancing increases returns by decreasing volatility drag; one makes the compound return higher and more similar to the arithmetic return. But rebalancing is more about risk management, than it is about increasing return. William Bernstein has written about the rebalancing bonus, which is the basis for rebalancing increasing returns. But he states at best, it is 1%. And that assumes that you’re rebalancing between assets with similar expected returns, similar comparatively high volatility and not highly correlated: basically, stock subasset classes. When it comes to rebalancing, most consider rebalancing between stocks and bonds more important than between stock subasset classes, as the former is materially more important to risk management than the latter. But stocks and bonds don’t have similar expected returns and similar volatility. If you want to increase return, you’re likely better off increasing stocks, rather than relying on the rebalancing bonus. However, rebalancing between stocks and bonds can make a lot of sense, when it comes to managing risk.
About volatility itself not leading to higher expected returns, I tend to think it’s a bit more complicated than that. I invest in stocks, and I’m hoping to get the market premium, the small premium and the value premium. Those who invest in bonds are hoping to get the interest rate premium. With all those premiums, there is a risk that you won’t get the premium and in fact may lose money. And you can make the case that volatility is a proxy for such downside risk. As a proxy, it lends itself to mathematical analysis of risk, which may be a reason why it’s so widely used.