By
iShares ETFs
:
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.
(click to enlarge)
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.
(click to enlarge)
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.
Source: Bloomberg
*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.
Original post
Disclaimer:
T
he 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.
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