Should I Own Bonds?
As Seen In the Fort Bend Independent
Many clients come to us having never invested in bonds, with little understanding of how they work and the advantages/disadvantages of owning this asset class. After stocks, bonds are typically the second largest asset class in a portfolio.
Bonds serve two functions in an investment portfolio. First, they provide income and a return of principal at a specific point in time. Second, they dampen the volatility of an all- stock portfolio.
When comparing bonds to stocks, we must consider real returns (returns after inflation). What is most critical to the long-term investor is the growth of purchasing power. Since financial assets are ultimately used to purchase “things,” the ability to achieve real returns is important.
If we compare the long-term real returns of stocks vs. bonds, there is no question which asset class performs best to achieve this goal. During the past two centuries, stocks have provided nearly a 7 percent return after inflation. Bonds, in contrast, have provided a markedly declining real return over time. In fact, since World War II, they have returned little over inflation. If this is the case, then why invest in them? Why not simply own only stocks? To reiterate from above, bonds can provide a guaranteed principal return (assuming no default of the issuer) at a specific point in time. For example, if you are saving for college for your child and you need the money in exactly five years, you can purchase a bond that matures in five years. They also are less volatile than stocks and provide a damper to an aggressive stock portfolio. The last several years of high volatility and stock market declines have demonstrated the benefits of owning bonds in a portfolio.
If we decide to add bonds to a portfolio (which we strongly suggest in most cases), the work has just begun. Several decisions must be made. First, should you own individuals bonds or bond mutual funds? If we are buying them for a specific goal and must have the money on a specific date, individual bonds may be the answer. If, however, they are a portion of a long-term investment portfolio, then a bond mutual fund may be more appropriate. The second decision involves the types of bonds to be purchased. Numerous types exist including, US Treasuries, and corporate, high-yield, tax-exempt and foreign bonds. Keep in mind that yield is not the only factor to consider when making your selection. What really matters is total return, which is yield plus potential appreciation. When considering taxable or tax-exempt bonds, you must also factor in your personal tax situation.
This portion of your portfolio requires the same careful selection as the stock portion. You should make sure you or your financial advisor give this area of your portfolio the appropriate amount of attention.
WJ Interests, LLC, has provided fee-only financial advice to individuals, families and businesses since 1996. For more information, please contact us at email@example.com or 281-634-9400.