Diversification, Asset Allocation and the Role of Bonds in the Portfolio [Part 3]
In my previous blog posts, I talked about diversification and asset allocation as key ingredients in building a portfolio to target performance and reduce risk to help you reach your goals and tolerate volatility. Bonds play a key role for many investors.
The Role of Bonds in your Portfolio
Bonds are different than stocks. Stock ownership is where you are a part owner of a business and you participate in the successes and failures. Bond ownership is where you are the lender to a business, person or government. As you likely know from borrowing money to buy a car or a home, there is a lot of paperwork and it seems like you are signing over your life to the bank. When you own a bond, you are the bank. You are the lender. You earn your interest payments, then get your money back after the term ends, just like a bank. One difference is that many bonds are interest-only, no principal. You get your principal back at the end of the term, not during the payment period. A bond typically has a lot of protections in place so that you have some assurances you will get your money back. You don’t have those same assurances with a stock, so bonds are often less risky. Of course, there are risky bonds too, so you need to know what you own.
An investor typically holds bonds to diversify and have a low or negatively correlated asset in your allocation. It does double duty. This allows you to dampen your risk.
Do Bonds still work as portfolio protection?
The short answer is “Yes”. The actual covenants in a bond provide some protection from a large loss. But, the diversification and asset allocation benefits of bonds are highly dependent on prevailing interest rates, and with record low rates, bonds do not provide as much portfolio protection during volatile times, like now. And the interest doesn’t give you much of a rate of return. So, why even own them? They still provide some protection, especially certain types of bonds. They still have a role in a portfolio to reduce risk so an investor can tolerate the volatility of stocks. But that protection is not as powerful as it has been in the previous decades.
What to do?
Perhaps nothing, but this is why investors hire a financial advisor. We help our clients balance risk and reward and alternative ways to protect a portfolio while still achieving your target performance. And, as a Fiduciary advisor, we must act in our client’s best interests and our compensation is based on the value of the portfolio, not the assets our clients own. Our Team can help.