Are bonds important for your investment portfolio? And what the hell have they got to do with bikes? Read on to find out……
Planning
Jack and Karl are planning a bike race. There’s nothing between these guys in terms of speed and ability, but Jack’s a data guy. He knows he can gain an advantage by making his bike lighter.
After a bit of analysis he realises three quarters of the race will be going up and just a quarter going down. Consequently, he figures, if he takes the brakes off his bike, it will be lighter and he’ll have an advantage for 75% of the race.
He knows it is a bit risky, but he’s sure he can handle it. Moreover, he thinks the potential gain is worth the risk.
Race day
On race day everything is going to plan. It begins with a big uphill stretch. Jack’s lighter bike does the trick and it doesn’t take long for him to develop a big lead. No matter how hard Karl pedals, he just can’t stop falling further and further behind. The race is not even half way through, but already looks decided.
Jack reaches the top of the first hill before Karl has made it half way. Jack looks over his shoulder and sees Karl struggling far behind. He sets off down the other side, forgetting his bike is missing something important!
Speeding down the hill, Jack reaches for the brake leaver………. It then dawns on him that he may have done something a bit stupid. Panic starts to take over as his speed rapidly increases.
He’s going so fast that he can’t see the bottom. He decides enough is enough and leaps off the bike, hitting the tarmac with a thud. He then scrapes a layer of skin off the underside off his body as he slides along the road. It ends with him smashing into a parked car.
Karl doesn’t notice Jack as he rides past gripping his brake leavers. Jack watches as Karl reaches the bottom of the hill and then slowly but surely makes his way up the other side towards the finish line. As Karl crosses the finish line he notices Jack’s bike lying on the ground.
It turns out that the momentum of traveling down the hill without brakes got Jack’s bike over the finish line first anyway……….without Jack!
How do you stop this thing
In this analogy bonds are the brakes. If you don’t have them you are likely to find it very difficult not to start panicking and jumping out of the market when it goes down 40%. Stocks will go up faster in the good times, but they are a whole lot scarier in the bad times.
There are a tonne of studies out there that show people can’t handle their money going down. In fact, a lot of very clever people have come to the conclusion that the pain of losing money outweighs the joy of making money by quite a bit.
Investors think they can handle their portfolio value plummeting until it actually happens and pure fear takes over. They end up panic selling everything at the worst possible moment, when it is cheapest.
They then either buy it back later at a higher price, thus losing lots of money in the process or worse still, many are so traumatised that they never return to the markets again.
And this is where the importance of bonds comes in.
Psychology
In theory, the way to make the most money in the markets would be to be 100% invested in stocks. However, due to the fact that most people can’t handle watching their portfolio’s value drop double digits, in practice, this isn’t the case.
A much better way to make money for most people is to have bonds in their portfolios. That way investors have a better chance of staying invested during the bad times. In fact, the more bonds you have, the happier you’re likely to feel in a market crash.
You shouldn’t underestimate the importance of bonds when markets crash.
In fact, think how good you’d feel if the markets crashed and you were 100% in bonds and the value of your portfolio went up, when everybody else’s portfolio was plummeting.
That would be a phenomenal feeling!
In reality though, having a portfolio without any stocks would be a bit over the top.
At the end of the day, the stock market tends to go up a lot more than it goes down. As a result, you would be loosing out on the great gains you get from stocks during the good times if you were all in bonds.
A split between the two is the way to go for most people. You can almost think of it as stocks to make money and bonds to preserve money.
How much of each you have comes down to your tolerance to risk. It’s easy to make sweeping statements about how high a tolerance for risk you have or don’t have, but this is something you really need to think about carefully.
What history tells us
In 2008 a portfolio split equally between global stocks and bonds dropped less than 20%. This compares favourably to a total stock portfolio which dropped over 40%.
A portfolio containing only bonds went up around 5%. Of course at other times stocks outperformed bonds. Over the last 30 years a total global stock portfolio would have gone up about 8.2%. A 50/50 split made 7.5% annually, and a portfolio containing all bonds increased 5.8% (I calculated these numbers using Portfolio Visualizer).
Rebalacing
Once you’ve decided how to split your portfolio between bonds and stocks, it is good practice to maintain that split by rebalancing.
If you were split 50/50 at the beginning of the year, but then stocks went on a bull run and increased in value so much that by the end of the year your portfolio’s split had changed to 60/40 in favour of stocks, you’d rebalance your portfolio by either buying more bonds, selling some stocks or both to the point where you were back to 50/50 again.
Perhaps the simplest way would just be to buy more bonds. In any case, there’s a wonderful psychological element to this. You are always going to be selling something expensive and buying something cheap.
Usually, you’ll be selling stocks to buy bonds, but in the bad times the roles might just be reversed.
The bottom line
In other words, bonds should be a critical component of everyone’s investment portfolio.
Stocks usually provide the big returns, but most investors can’t handle the ride. Not without the stability they get from bonds that is.