“Begin with 100 and subtract your age. Own the resulting percentage in equities and the rest in bonds.”
If you’re like most investors, you’ve heard the common wisdom on owning bonds many times. It’s simple, easy to remember and has been the rule of thumb for at least 40 years. But in this era of rock-bottom rates, does anyone still subscribe to it?
To find out, we analyzed the asset breakdown of Personal Capital users in the “Mass Affluent” group; those who have $100k-$2mm in investable assets. Investable assets include cash, stocks, bonds and alternatives such as gold and commodities, but exclude physical real estate and other illiquid holdings. Currently, we have over 100,000 users of our free Financial Dashboard who fall into the Mass Affluent category, allowing us an unparalleled view into how these folks actually position themselves in the market. Overall, we have over 600,000 users of our technology spread across the entire net worth range.
As we looked under the hood, the results are pretty staggering. To clarify, the following data is a representation of the entire user base who have aggregated between $100,000 to $2 million, and are not a representation of Personal Capital’s clients.
We are seeing a huge underweight to both US and international bonds when compared to the “conventional” wisdom. Following the rule, we’d expect the Mass Affluent age group of 20-34 to allocate around twenty-seven percent of their portfolios to bonds. What do they actually own? Nine percent, only a third of what’s expected. And because bonds generally represent the most stable portion of an investor’s portfolio, it’s a very aggressive adjustment.
But, OK, it’s a bunch of 20 and 30 year olds, and aggression comes with the territory. What about the others?
It turns out that the 20-34 year olds are actually the least underweight to bonds of any age group! As mass affluent users grow older, their allocation to bonds should rise significantly, especially as they reach retirement age. And while we did see a small, incremental increase in bonds in their portfolios, it doesn’t begin to keep pace with where they should be according to conventional wisdom. Seeing 75-89 year old investors with more than 50% of their money still allocated to equities is almost unheard of.
These are investors who are no longer earning salaries, so their portfolios are less able to weather the volatility that comes with an equity-heavy allocation. If there is a large drop in the stock market, they will be unable to wait out a recovery, and may have to adjust their standard of living sharply downwards. This is not a risk to be taken lightly, but the relatively smooth gains in stock prices over the last five years have lulled many investors into a sense of complacency.
Bonds just can’t seem to compete. Yields are at historic lows, and show no signs of increasing in the near future. While the Fed has recently ended their latest round of quantitative easing, they were clear in their intention to keep rates low. And an eventual rate hike would only seem to make things worse. Since bond prices move inversely with yields, as rates do begin to recover bond prices will likely be pressured downwards. Under the circumstances, shunning fixed-income seems like a no brainer.
ON THE BRIGHT SIDE
Despite the potential risk, the big picture may not be that bleak. Historically, the role of bonds in a diversified portfolio is to generate income and provide stability. Despite low yields, bonds can still do both of these. Not owning them means holding more cash or stock instead. Cash is a sure way to lag inflation, while stocks come with more risk than is appropriate for some investors. Bonds strike a middle ground, yielding more than cash with only a small fraction of the volatility of stocks.
Part of the problem is the widespread fear of bond prices plummeting as rates rise. But is the fear warranted? Passive fixed income funds ladder their bond portfolios, meaning they contain bonds which mature at different times. In a rising rate environment, older maturing bonds would be replaced with bonds yielding the new, higher interest rate. Therefore even if bond fund prices dropped in the short term, that loss would immediately begin to be offset by higher absolute returns from within the fund. After a few years of holding it, you’d likely have more money than if rates had never moved upward.
While many investors are obviously ignoring the common wisdom on fixed income, it’s not yet time to declare it dead. Over the past several market cycles, bonds have been instrumental in offsetting the depreciation risk of cash and the volatility of equities, and low current yield is not enough reason to throw in the towel. Those investors and pundits who have been predicting a big drop in bond prices have been wrong for a long time now. Will they be correct someday? Maybe, but it could be a long, risky wait.
Graphs by Caroline Sohr
Picture by Homsi Flickr Creative Commons