Should Young People Hold Bonds in Their Retirement Portfolios?

Investing Guide asks should young people carry bonds in their portfolio?” This is question that I have mulled over before as well. I agree with Loi that “there have been some conflicting advice on whether young people should have bonds in their portfolio.” Personally I have been through one bear market already (without any fixed income) and I do not want to go through another one without bonds in my portfolio. Some of you will know what I mean. Others will not know the agony of seeing your portfolio’s value fall month after month as the stock market tanks. However, “having some bonds (15-20%) in a portfolio lowers downside risk by a large amount.” This is one of the key reasons that I want to have some bonds in my portfolio, to reduce downside risk.

The second reason that I want have some bonds in my portfolio is because Benjamin Graham says so (at least 25% bonds). Benjamin Graham knows what he is talking about. He was around for a long time, during the depression, post-depression and all the way until the 1970s. He has seen many ups and downs. In the Intelligent Investor (1973 edition) he says that:

even high-quality stocks cannot be a better purchase than bonds under all conditions–i.e., regardless of how high the stock market may be and how low the current dividend return compared with the rates available on bonds. A statement of this kind would be as absurd as was the contrary one–too often heard years ago–that any bond is safer than any stock. [emphasis his]

At the end of the chapter, after much discussion (you will have to read it), he concludes that

Just because of the uncertainties of the future the investor cannot afford to put all his funds into one basket–neither in the bond basket, despite the unprecedentedly high returns that bonds have recently offered; nor in the stock basket, despite the prospect of continuing inflation

In Chapter 4 he addresses bond-stock allocation in more detail for the defensive investor. It can be summarized as the following:

He should divide his funds between high-grade bonds and high-grade common stocks. We have suggested as a fundamental guiding rule that the investor should never have less than 25% or more than 75% of his funds in common stocks, with a consequent inverse range of between 75% and 25% in bonds.

Note that Graham does not discriminate by age. Jason Zweig goes on in his end-of-chapter why going 100% stocks may be ok for a small minority of the population:

For a tiny minority of investors, a 100%-stock portfolio may make some sense. You are one of them if you:

  • have set aside enough cash to support your family for at least 1 year
  • will be investing steadily for at least 20 years to come
  • survived the bear market that began in 2000
  • did not sell stocks during the bear market that began in 2000
  • bought more stocks during the bear market that began in 2000
  • have read Chapter 8 (The Investor & Market Fluctuations) in this book (The Intelligent Investor) and implemented a formal plan to control your own investing behavior

Personally I do not think I fit into this small minority. Secondly I think that going with a 100% portfolio goes against my third and final reason for wanting some bonds in my portfolio: rebalancing. If you have a 100% stock portfolio and the market tanks by 20% this year you cannot take advantage of rebalancing. If you have a 75% equities, 25% fixed-income/bond portfolio and the stock market tanks by 20% this year, your allocation will shift to 71% stock, 29% fixed-income/bonds. Assuming you can do this in a low-cost fashion, you can instantly get a hold of cheap stocks by selling part of your bond portfolio and buying equities.

Getting back to the whole age thing, I do not think it really matters. When you get really old you should obviously be more focused on income and capital preservation than when you are young. But I do not think people in their 20s should invest any differently than people in their 30s and 40s. That is, I think they should have some bonds in their portfolio no matter what. Capital preservation should be just as important to someone in their 20s. And as Loi mentioned in his article, the average return of a 100% stock portfolio from 1960-2004 was 10.5% whereas the average return for a 80% stock/20% bonds portfolio was 10.1%. I haven’t verified those figures but I have seen similar graphs and numbers quoted before so I am not surprised. I cannot think of why anyone would not want to take a small 0.4% hit on their return for the lower risk offered by a mixed bonds/stocks portfolio.

Initially my advisor did one of those risk surveys on me and I fell into the 100% equity category. Unfortunately those risk surveys are seriously flawed. Just because you have held stocks and mutual funds in the past, have a 30+ years time horizon, have a sound knowledge of investing, and can answer a bunch of other basic questions does not mean that you should automatically be in a 100% equity portfolio. I insisted that I have 25% fixed income (à la Graham) so my new portfolio at Clearsight will hold 25% TD Canadian Bond fund for now (great for rebalancing with as their are no commissions as with ETFs).

15 thoughts on “Should Young People Hold Bonds in Their Retirement Portfolios?”

  1. I agree with you. Currently I don’t have any bonds in my portfolio (actually, some of the funds held with my advisor have a bond component so that isn’t totally true) but this year I want to buy a few bonds. The problem that I have is that the yield on them is so low right now.

    I have one minor difference of opinion on what you have said about older people needing to have more bonds than younger people. For the most part that is probably true however, the issue isn’t really the age of the investor, the issue is what the investor is using their portfolio for and when they expect to need the money. Some one like Derek Foster (who retired at 34) may have a higher percentage of bonds than the average 34 year old that doesn’t expect to draw on their retirement account for another 25-30 years (actually I think Derek doesn’t have a very large precentage of bonds in his portfolio but I just used his name to make the point).

  2. Dave: TD Canadian Bond Fund has a MER of 1.07%, when 10 year bonds are yielding 5%. I think the fund is a bit expensive (though not as expensive as some other bond funds). If you have a large enough portfolio, you might consider holding a ladder of bonds. In a smaller portfolio, there are plenty of GICs that pay a decent yield and will be a snap to construct a ladder. Action Direct, for instance, is offering a 5-year GIC at 4.42%.

  3. In Bernstein’s “4 Pillars”, he has a 100% stock portfolio with a 9.89% annualized for 1901-2000 and a 75/25 at 8.74. The std dev difference is about 15%(!).

    One other question about bonds is whether you have liquid debt (e.g., credit card, home equity line) that you could pay off instead of buying bonds. Mine HELOC is at 8%, so my plan is not to buy any bonds until I have that paid off.

    I agree with OxCC above – it depends on when you’re going to need the money, not how far away you are from retirement.

  4. Good post and good points. I’m thinking more like 15-20% bonds, but I’m definitely going to have some in there.

    1.07% ER on a bond fund does sound a bit high though.

  5. CC: These are the average returns for the TD Canadian Bond fund for the last 5 years after the MER:
    2005 6.4
    2004 7.2
    2003 7.7
    2002 9.0
    2001 6.4
    2000 11.1

    So in 2005 I would have to get 7.4% on my own to match the performance of this fund. That might be hard to do seeing as 10 yr. yields were at 4-5% in 2005 as you say. I do not know the details of how they manage to get such good returns. My advisor did say that down the road, once my portfolio gets big enough we can just buy our own bonds, as you suggested, to avoid the MER.

  6. Dave: Note than any bond fund’s annual returns includes changes in the value of its bond holdings. Last year, yields on most bond maturities fell (and prices would have increased as bond yields and prices move in opposite directions). If yields rise this year (they have been rising recently), a bond mutual funds returns will be the coupon interest less any negative change in the value of its holdings.

    IMHO, 1% is a steep fee for a bond mutual fund, when cheaper alternatives exist (XBB, for instance).

  7. CC: interesting, actually I had thought that a bond fund’s annual returns included changes in the value of its bond holdings, but I had assumed incorrectly that it only included realized value. Not sure why I assumed that. Anyways, my advisor and I did talk about XBB before, as well as looking at buying individual bonds. I’ll have to look into these possibilities a little more closely. I guess the main question would be whether active management in bond markets is as (in)effective as it is in equity markets? As you noted this fund has beaten the benchmark 4 out of the past 5 years but I wonder how likely it will be that they can repeat that performance?

  8. I’m enjoying your stories that tie your personal situations to the post more and more.

    I think for young people, another factor in the allocation has to be their goals for the money. Goal-oriented allocation means that short-term, long term goals play a major part. Most people will have a weak heart for putting money into equities with the looming prospects of a home purchase within 5 years.

    The equity portion can be oriented for retirement goals while bond portions can geared for short/mid-term uses. I myself, don’t see much point of holding short term investments for any reason, any age and I’m glad Ben Graham felt the same. Admittedly, this model may skew the ratio more towards bonds, depending on what stage of life the young people are in.

    I prefer to have any bond portion tucked inside an RSP, and being able to leverage the home buyer’s program. And keeping as much of the tax advantaged equity investments outside.

    The Intelligent Investor is an amazing book, one of my must-reads for people looking to get into investments.

  9. Why focus on the 1% fee when the fund has beaten the index 4/5 years? The reported returns are net of the fees anyways, meaning that the fund actually did 1% better than reported, right?

    For example, if an advisor charges more but consistently outperforms the market, I don’t see the hesistation of fees should come into play.

    There is such a thing as being frugal and overhead conscious, but don’t forget that quality doesn’t necessary come cheap. What’s important is the quality and consistency.

  10. Investorial: Interesting you mention the home buyer’s plan… I have been meaning to write a post about this.

    “The reported returns are net of the fees anyways”

    I fully agree. I almost never look at MER to be honest because as you say, the reported returns are always net of the fees anyways.

    “For example, if an advisor charges more but consistently outperforms the market, I don’t see the hesistation of fees should come into play.

    There is such a thing as being frugal and overhead conscious, but don’t forget that quality doesn’t necessary come cheap. What’s important is the quality and consistency.”

    Well said and I have nothing to add to that. I just copied it out verbatim so more people see it. 🙂

    Well I do have one more thing to say. A real live example. Ross Healy’s Accumulus Talisman Fund collects 1.95% MER every year plus 20% of the amount the fund outperforms the S&P/TSX 60. How’s that for an MER. You could be looking at well over 2% MER there. At the end of January it’s one-year performance was 30.4%. They do not have much long-term performance since they’ve only been around since February 2004.

  11. Hmmm… this might turn out into yet another active / passive investing debates but with reference to bond funds. If a bond fund beats the index, it means they do something different from the index that is working. The question you have to ask yourself is: will it work all the time in the future? Maybe, maybe not.

    The evidence seems to be that a significant majority of funds underperform their indices. Of course, there are some exceptions and hopefully TD Bond Fund is one of them.

    FYI: 10 year returns of TD Bond Fund is 7.9%. The benchmark index would have returned 7.67% over the same period.

  12. Thanks CC, the 10 year return means a lot more than any more recent returns. The 0.23% difference is very small.

    Actually, I’m not sure where you are looking, but on globefund, it says 7.72% (10 yr) for the benchmark as of the end of February 2006 and 7.94% for the fund. They also show the 15 yr though which is 8.99% for the benchmark and 8.69%, so if we look at the 15 yr the TD Canadian Bond Fund actually did worse! Interesting. The index globefund is comparing it against is the SC Universe Bond Total Return Index.

  13. Perfoming better than an index is almost impossible over long periods of time. And when fees are not in your favor, neither are the odds.

  14. klauss, sounds like Malkiel talking… and I just started reading A Random Walk Down Wall Street this morning. I going to totally be an indexing nazi after reading that book.

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