If you look at an index-based stock price chart over the past two years, you're looking at something reminiscent of a polygraph test gone bad. Indeed, while the S&P 500, as measured by large cap tracker SPY, has mostly traded in a somewhat tight 185 to 210 range for almost two years now, sudden rises and drops have caused investors roller-coaster-like thrills and heart palpitating spills in the meantime.
Unfortunately for the less intense ride goer, this pattern isn't likely to stop anytime soon.
Equity valuations, a less than clear domestic and international macroeconomic outlook, plummeting oil prices, China-growth concerns, and Presidential campaign rhetoric, among other things, are all creating a rather tenuous situation today for investors.
While it's uncertain as to which direction stocks may break out next, stock price volatility, like death and taxes, may be the only thing we can rest any level of certainty on for now.
Are You Over-Allocated To Stocks?
Though the recent price plummet may be disconcerting to some, others may be viewing the situation with a more apathetic attitude. Investors of different types, experience, and life situations are bound to have widely varying reactions to stock volatility. Therefore, since none of us owns an accurate crystal ball, we need to make "free" decisions that can help sidestep potentially costly emotional reactions.
As I've opined time and time again, investors who invest with thoughtful asset allocation and diversification are likely to hold up better during market volatility. Those who concentrate without strategic asset allocation preparation are likely to find themselves stuck or constantly second-guessing themselves.
Once you find a wheelhouse of allocation, things become much easier. Although, arguably, it's something that you may need to fine-tune on an occasional basis or even make meaningful change to when life or economic situations dictate.
The Role Of The Bond
There are several reasons to own bonds. The most general reason may be as a simple diversification tool for equity-heavy portfolios. Bonds that sit at the highest band of credit worthiness, sometimes known as the "AAA" bond, might also be viewed as a means of capital preservation. While there is generally no insurance mechanism in a bond, high grade bonds have an extraordinarily low risk of default. Still, the risk is not zero, so even the safest of bonds should not be viewed as totally risk-free.
Income generation is another big reason to own bonds. Depending on the length to maturity and credit worthiness of the issuer, bonds can pay virtually nothing in interest all the way up to double digits of interest. The more risk you are willing to take, either in terms of time till maturity or underlying credit, the more interest you can potentially earn.
From a bird's eye perspective, it is conceivable that some investors may have no reason to own bonds, while others may exclusively own bonds. The preponderance of investors probably sit somewhere in between.
For retired investors living with a defined pension or on Social Security, these monies should probably be deemed "bond-like," since there is a periodic payment mechanism in place that acts just as bond interest payments might. But, like bonds, there is generally no guarantee. Workers in the city of Detroit have found that out first-hand. Public pensions nationwide are under pressure given rising obligations as retirees live longer and as receipts and underlying investment performance fails to keep up with receipts from new workers and employers.
There is no standard input engine that spits out the required percentage of bonds one should own. Old rules of thumb like subtract your age from 100 are super-simplistic and should not be relied upon in a more complex investment age. Increased life expectancy and lower rates of interest have also rendered financial planning tools like the "4% rule" somewhat moot in a new braver world. ZIRP has also made the cash rewards of investing in bonds much less attractive compared to days of yore when you could get double-digit Treasury and CD interest.
If volatility has gotten you to question your overall strategy, there's the potential that adding bonds or even other sorts of assets may help you sleep a little better at night. Stocks are not the only strategic game in town -- don't make the mistake of investing like they are.