Why Invest in Bonds?

The first step to building an asset allocation plan is coming to the understanding that your portfolio is the sum of many asset classes. Each asset class has its own risk and reward relationship which will have a direct impact on how your portfolio responds during different market conditions. Why Invest In Bonds? A portion of your asset allocation should be dedicated to bonds for their unique characteristics.

Bonds in general are known for there stability and predictability of returns. They generally have a low standard deviation which means that they are less risky than most other asset classes. When combining a bond index with your overall portfolio you will lower your standard deviation and annualized return. Most likely you are thinking why invest in bonds if it’s going to lower my annualized return! In general when you add bonds to a portfolio you reduce your standard deviation, which is risk, at a much faster rate than your annualized return.

Risk and Reward Chart Help

The asset classes used to create the above risk and reward chart was 100% Total Stock Market, and 100% Total bond. The very right hand point would indicate 100% Total Stock market while the very left hand point would be 100% Total Bond Market. In-between the points are various combinations of the two asset classes in 5% increments.

As you can see from the chart above, when you start adding bonds to a portfolio, your standard deviation decreases as does your annualized returns. However, you should also notice that adding bonds reduces risk a lot more than it reduces your returns. For instance, in the above assets adding 20% bonds only reduces annualized return by 1% while at the same time reducing the standard deviation by 4. You have just reduced the return by only 1/11 while reducing risk by almost 1/4.

Another benefit to of having some bonds in a portfolio, and why you should invest in bonds, comes in the form of re-balancing and correlation. As we know stocks and bonds do not perform the same to various market conditions. When one asset class of your allocation drops your bonds may move higher and visa versa. This will allow you to re-balance back to your predefined asset allocation which will result in you automatically buying low and selling high.