Should You Have Bonds in Your Investment Portfolio?

Should You Have Bonds in Your Investment Portfolio?

If almost 90% of investment returns come from asset allocation, then the decision on what asset classes to hold in a portfolio could be critical. Many rules of thumb may prescribe an allocation to bonds, but does that recommendation make sense for all investors? It depends.

Published by Motley Fool Wealth Management Wed, Jan 11, 2023

read time 6 min read

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88%. That’s the percentage of return that comes from asset allocation for most investors.1 So it’s considered the most important investment part to get right. Because of its significance, many investors follow certain rules of thumb. For instance, traditional rules of asset allocation call for an age-appropriate mix of stocks and bonds that gradually favors the latter as the investor gets older.

One common rule to determine the appropriate amount is to take the investor’s age and subtract it from 110 to get the ideal stock allocation, with the rest in bonds. So, a 30-year-old investor—by this rule2—should have 80% of their portfolio invested in stocks, with the other 20% in bonds. By the time they’re 50, the mix should be 60/40–which is a common retirement asset allocation. There are many other variations of asset allocation rules, but you get the idea.

This brings up some important questions. For one thing, does a 30-year-old investor who is still decades away from retirement need to keep 20% of their assets in bonds? Or, would an all-stock portfolio make more sense, especially for younger investors or even for retirees who expect to live a few decades in retirement?

Let’s take a closer look at where the traditional asset allocation rules come from and what the historical performance figures tell us.

Asset allocation rules: Why bonds?

The general idea behind traditional asset allocation rules is quite simple. Many agree that stocks have higher long-term return potential than bonds, but also can be far more volatile over shorter periods. I’ll spare you a statistics lesson but based on the historical performance of the S&P 500 from 1965 through 2022, total returns of as much as 46% or as low as negative 23% in any given year would be considered “normal.”3 So, the idea is that these assets are considered best suited to investors who have decades left until they’ll need their money, and not so much for investors who can’t deal with massive short-term fluctuations in their nest egg.

On the other hand, bonds have lower long-term return potential, and although the market value of bonds can vary over time, they historically tend to be far less volatile than stocks over short periods. Plus, they are designed to produce consistent income, making them potentially worthy choices for investors who need a predictable stream of money.

Historical performance of various stock/bond allocations

Let’s put some numbers behind these ideas. An analysis of stock market and bond market returns from 1926 through 20214 shows how portfolios of various asset allocations performed over that 96-year period.

It might not surprise you that a 100% stock portfolio would have produced the best long-term returns. From 1926 through 2021, the average annualized return of an all-stock allocation was 12.3%.

What might surprise you is the long-term effect of adding just a small allocation of bonds into the mix. Under this analysis, a portfolio of 70% stocks and 30% bonds would have achieved a 10.5% annualized return. This might not sound too different from the all-stock portfolio’s return but, consider what it would mean over the long run.

Here is one hypothetical. Let’s say you start a portfolio when you’re 25 years old and contribute $5,000 annually. Based on the historical returns of the 70/30 mix, this investment strategy could be expected to produce a $2.8 million nest egg by the time you’re 65. Not bad, right? However, based on the 12.3% historic return of an all-stock portfolio from our analysis above, the same investment amount and time horizon would grow to nearly $4.7 million.5 That’s a big difference in your financial security in retirement.

Of course, there’s no guarantee that past performance will match future results. All investing involves risk and may lose money, including principal.

And while to many the biggest risk of an all-stock strategy is reaching retirement age during a major market downturn, it might not make as much of a difference as you think. Historically, the worst year for a 100% stock portfolio in our 96-year analysis was a negative 43.1% return, while the worst year for a 70/30 mix was negative 30.7%. In short, a bad year could be bad for your portfolio, even if you own substantial bond allocations. The stock market produced negative total returns in 25 separate years from 1926 to 2021, and a 70% stock, 30% bond portfolio would have only avoided losses in two of those 25 down years (out of the 96).

It’s also worth noting that since the end of 2022, the stock market has had 13 negative years since 1965, and the average total return in the following year was 13.1%.6 In other words, history has favored a rebound over time.

Another surprising finding from this analysis is that bonds aren’t the “sure thing” many investors believe them to be, especially when it comes to holding their value. Over the 96-year period in the analysis period, a 100% bond portfolio would have produced a negative total return in 20 separate years. Think about that for a second—a portfolio made up exclusively of “low-risk” fixed-income investments would have lost money 21% of the time.

Bonds and you: A good match?

Of course, every investor has different goals, spending habits, and risk tolerance. And we believe any money that you’ll need within the next three to five years for a major expense or to fund your day-to-day life shouldn’t be in the stock market. And for some investors, an allocation to fixed income investments (or even to cash equivalents like CDs) may make sense.

Additionally, there is no number of statistics and historical performance figures that can replace the peace of mind that “safer” investments can provide certain investors. If allocating some of your investment portfolio to bonds, CDs, or other low-risk, low-return investments helps you sleep better at night, it’s certainly not worth trading your mental health for the probability of better long-term returns.

Having said all of that, the historical data is clear to us. If you still have decades until you retire, or even if you’re older and don’t anticipate needing to cash out your investments anytime soon (for example, if you plan to leave your investment portfolio to heirs), we believe the best chance for potential higher long-term returns is a stock-heavy asset allocation.

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Footnotes

1Vanguard, The Global Case for Strategic Asset Allocation, 2012

2Calculated by Motley Fool Wealth Management, Dec. 2022. Data for the S&P 500 total return index from 1965 through 2022.

3Data sourced from Berkshire Hathaway, Warren Buffett's 2022 letter to shareholders, Feb. 26, 2022. Calculations by Motley Fool Wealth Management. Normal performance is statistically defined as being within two standard deviations of the average total return.

4Vanguard. Data for the U.S. stock market returns comes from the Standard & Poor’s 90 Index from 1926 to March 3, 1957, and the Standard & Poor’s 500 Index thereafter. Data for the U.S. bond market originates from the Standard & Poor’s High Grade Corporate Index from 1926 to 1968, the Salomon High Grade Index from 1969 to 1972, and the Barclays U.S. Long Credit Aa Index thereafter. Data for U.S. short-term reserves is from the Ibbotson U.S. 30-Day Treasury Bill Index from 1926 to 1977 and the FTSE 3-Month U.S. Treasury Bill Index thereafter. Past performance is no guarantee of future returns. The performance of an index is not an exact representation of any particular investment, as you cannot invest directly in an index.

5Calculations by Motley Fool Wealth Management, Nov. 2022.

6Berkshire Hathaway annual letter to shareholders, Feb. 26, 2022. 13 negative years includes 2022, but the 13.1% is from 1965 through 2022—or 12 negative years. It does not include the year following the 2022 decline since that period has not yet passed.

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