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 US investment grade bond market. For aggressive investors young and old, there are some riskier sectors to be found in fixed income, such as high yield (like the iShares iBoxx High Yield ETF – HYG) and emerging market bonds (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.