What Investors Need to Know About the Role of Bonds in your Portfolio

By WEALTH Magazine Staff | Print This Article

As you know, a bond is a security in which the issuer promises to pay you, the purchaser, a set interest rate for a fixed period of time for the use of your money. Bonds are generally less volatile than stocks and are considered safer because bonds are often secured by the assets of the issuer.

Also, bonds are usually a good hedge against stock investments. Why? Because bonds often go the opposite direction of stocks. When stocks are hot, bonds are not. But when stocks sag, bonds often perk up.

Some experts subscribe to the theory that bonds do not need to be a part of your portfolio. Why? Because over a long period of time, stocks tend to outperform bonds. But because you’ve been following investment news, you know that past performance does not guarantee future profitability. In other words, there is no guarantee that stocks will perform over the next 10 or 20 years the same way they performed in the previous period of time.

So bonds can be a hedge against poor stock performance.

How much of your portfolio should be invested in bonds? Only you can answer that question. But generally, the younger you are, the more time you have to make up any losses in more volatile investments such as stocks. So most experts say the younger you are, the higher percentage of your portfolio should be in stocks rather than in bonds.

One rule of thumb is that if you subtract your age from 100, the result should be the percentage of your portfolio in stocks, with the rest going to stable investments like bonds and cash. Such a rule of thumb may be too conservative, and we don’t necessarily endorse it.

However, we also don’t recommend that you ignore bonds completely. They may still have a place in your portfolio. One strategy many experts recommend is to “ladder” your bond investments. Laddering means you are spreading the maturities of your bonds across several years. This helps diversify your portfolio, reduce price volatility, and spread out reinvestment risk over a range of potential interest-rate environments – all of which may help improve your overall return.

Finally, remember that in today’s environment, the federal government is keeping interest rates low to stimulate the economy. So you don’t want a lot of your money tied up in long-term bonds. If the economy takes off and rates increase, you would be in a position where you couldn’t capitalize on the changes. And you always want some degree of flexibility to respond to a changing market.

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