It's a common misconception: Bonds are for older investors, stocks are for younger investors. As with many myths, there is a bit of truth mixed in - an older investor at or nearing retirement age wants the conservative risk profile and income generation inherent in bonds, while a younger investor seeking growth potential is more likely to favor riskier investments that provide more opportunity for long-term growth.
While I agree that an investor's mix of stocks and bonds should change as they grow older, the reality is that fixed income can play an important role in any portfolio, regardless of the investor's age. In fact, I would argue that there's really no time in an investor's life where it makes sense to be 100% invested in equities. The reality is that asset class diversification is too beneficial to ignore - for all investors.
Take a look at the two efficient frontiers below. Each represents a range of hypothetical portfolios that can be created by combining different asset classes. The orange dots show possible portfolio combinations using a selection of equity asset classes, while the light blue dots show the portfolios that include both equity and fixed income*. The graph shows the hypothetical return and risk each portfolio combination would have had over the past 10 years. As you can see, the all-equity portfolios had to take on much more risk in order to generate a return similar to that of the portfolios that included bonds.
This idea has been especially poignant given the market conditions we've experienced the past couple of years, since bonds have weathered the recent financial crisis better than equities. As you can see from the chart below, starting from the beginning of the 2008 financial crisis, an all-equity portfolio would have fared worse from both a risk and return perspective than a balanced portfolio (one that includes equity and fixed income investments). Having bonds in a portfolio helped to soften the downside experienced by stocks in 2008-2009, and therefore helped the balanced portfolio to rebound more quickly when the market turned around.
For illustration only-not indicative of any investment. Index returns do not reflect management fees, transaction costs or expenses and one cannot invest directly in an index. Past performance does not guarantee future results.
So how should young investors think about using fixed income? Well, there are a few rules of thumb out there that provide guidance on what percentage of a portfolio should be bonds, the most well-known being the 60/40 rule (60% equities and 40% fixed income). This likely works best for investors transitioning from "younger" to "older" (no one likes to be called middle aged!). Another popular method is to subtract your age from 100, and that number is the percentage that should be invested in stocks, with the rest in bonds.
As for what to hold in your 40% (or 30%, or whatever your fixed income allocation may be), the answer really depends on the role fixed income is playing in your portfolio. If the goal is simply to balance the portfolio, then a diversified bond ETF such as the iShares Barclays Aggregate Bond Fund (AGG ) could fit the bill. AGG 's index is designed to represent the total USinvestment grade bond market. For aggressive investors young and old, there are some riskier sectors to be found in fixed income, such as highyield (like the iShares iBoxx High Yield ETF - HYG) and emerging marketbonds (like the iShares JP Morgan USD Emerging Markets ETF - EMB). No matter what fixed income sector is the best fit for you, remember that diversification is an important part of portfolio strategy at any age. And that's no myth.
*The efficient frontier chart was created using monthly historical index data over the past 10 years ending 7/31/12 for the following indexes: S&P 500, MSCI EAFE, MSCI Emerging Markets, Dow Jones US REITs and Barclays US Aggregate. For illustration only-not indicative of any investment.
Disclaimer: The hypothetical portfolios are based on index performance. Index returns do not reflect management fees, transaction costs or expenses and one cannot invest directly in an index. Past performance does not guarantee future results.
Bonds and bond funds will decrease in value as interest rates rise. The Funds are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity. In addition to the normal risks associated with investing, international investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles or from economic or political instability in other nations. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.