How stocks and bonds should fit in your portfolio

When clients join our Successful Investor Wealth Management service, they often ask us whether they should hold bonds or focus more heavily on stocks. This is a particularly important question for investors who rely on their portfolios for income.

It’s important to note that there is no single “best portfolio” for every investor. Higher potential for loss comes with higher potential for returns, so the question of whether to hold stocks or bonds depends partly on your temperament and financial goals.

Bonds provide steady income and a guarantee to repay the principal at maturity, so lowering your common stock exposure in favour of bonds can have some positive effects. First, you may reduce your portfolio’s overall volatility. Second, you are likely to cut your overall risk of loss.

However, bonds have a number of drawbacks that can weigh on your portfolio’s overall returns, especially in today’s investment climate.

Stocks and bonds are likely to go in different directions in coming years

The performance of bonds is inversely related to the rise and fall of interest rates; when rates fall, bond prices go up. The opposite is true when rates rise.

Bonds can be desirable or not, depending on current interest rates and the inflation outlook. Back in the mid-1990s, we advised most investors to put one-third to two-thirds of their portfolios in bonds. Back then, inflation was on the high side, and likely to shrink, so it presented a falling risk to bondholders. Bond yields were likely to fall, which meant that bond prices were likely to rise. To top things off, bond yields at 8% or so were up close to the long-term, 8% to 10% return on stocks.

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Today, that situation has reversed. Inflation is low now, but is likely to rise as the economy recovers in the next few years. As that happens, bond yields will go up, which is another way of saying that bond prices will go down. Meanwhile, current yields on bonds are half of what they were in the mid-1990s — in other words, they provide around half the average long-term return on stocks.

These are just some of the reasons why we continue to recommend that most investors hold most of their portfolios in stocks, and bonds only make up a small portion, if any. Moreover, to maximize your stock portfolio’s safety and income potential, you should focus on well-established companies with long histories of dividends, or mutual funds that hold these stocks.

Above all, you should avoid putting money in poor-quality speculative investments, or any sort of options trading. That’s because these investments heighten your risk, and increase the odds of a total loss.

Right mix of stocks and bonds depends on your temperament and financial goals

In the end, the right mix of stocks and bonds (or whether you should hold bonds at all) depends on your financial circumstances and temperament. If you are older, and are planning your retirement, you may want to hold some T-bills or short-term bonds that mature in two or three years. This will cost you a couple of points in yield, at least for the next few months. But it will protect you from a substantially bigger drop in value. That’s because a rise in interest rates will have a greater impact on bonds with longer terms to maturity.

Sometime in the next six months to, say, two years, we expect a significant rise in interest rates. If so, you’ll be able to sell your T-bills and short-term bonds and reinvest the proceeds in longer-term bonds yielding substantially more than they do today.

If you’d like me to personally apply my time-tested approach to your investments, you should consider becoming a client of my Successful Investor Wealth Management service. Click here to learn more.