How much do you really need in bonds?
Disclaimer: This guide should be read in conjunction with the mini-guides on asset allocation (Stocks & Bonds, Real Estate & commodities) so you may better understand the expected pros & cons of each asset class;
The purpose of these guides is to lay out the plan for building a successful investment portfolio for any investment profile. My hope is that by the end of this guide, you would have learned how to build the right bond allocation that works for you, both in terms of expected performance and acceptable risk.
In this guide you will learn:
1. How much you should have in cash & bonds to ensure you are never wiped out;
2. How to tailor your bond allocation to your investment profile;
3. How much bonds you really need and why your personal situation matters more than you think.
Personal finance in asset allocation
Asset allocation merges personal finance and investing. Asset allocation is about optimizing your finances to help ensure you have the means to pay next month’s rent and enjoy a comfortable retirement.
For example, as we learned in the mini-guide on stocks & bonds allocation stocks have the highest rate of return of any asset classes over the long term, you may be tempted to pour all your money in stocks to get rich faster. However doing so may place your personal finances at risk: if all your money is in stocks, how will you pay for your next meal?
For this reason, we all need to have sufficient cash and liquid assets on hand. But how much is enough? And even if you make the responsible choice and set aside a large sum of money for emergencies, these emergencies may not occur for the next 10 years. Over that time, inflation would have eroded your savings by almost 20%. So if not cash then where?
Bonds & money market funds are great alternatives in this regard as they yield higher returns than savings accounts. However, as it can take a few days to take funds out of a money market fund or bonds, you should always keep some cash on hand to bridge this delay. Additionally, there can sometimes be small transaction fees to take money out. As such, it isn’t optimal to use bonds & money market funds as a checking account. However, they do make for great emergency funds.
So how much should you have in each? Here’s an example of how your personal finance could look like:
Cash – you must hold enough cash to cover immediate expenses (e.g. food, rent, utilities). This should be at least one month of living expenses;
Savings – You should have enough savings to cover unforeseen expenses (e.g. car repair, leaky ceiling, or a medical bill). This should be at least another month of living expenses;
Bonds / Money Market Funds – You should always stash away funds for an emergency, but keeping it in cash and savings isn’t optimal as inflation will eat it all away. Money market funds & bonds are suitable alternatives but how much you should hold in these will depend on your personal situation (more on that below!).
How much should you have in bonds?
The answer to this question will be different based on your personal circumstances, investor profile, and portfolio composition but the main message remains constant:
Bonds will provide for living expenses in bad times while stocks will pay for living expenses in good times. Make sure you have enough of both to live comfortably in both times.
The reasoning is sound. Stocks provide higher returns over the long term but you have to give them time to grow. If your portfolio is 100% stocks, you will eventually need to sell stocks to pay for living expenses. This works well in good times, as your stocks will grow relatively quickly. However this is a recipe for disasters in bad times, as stocks may lose over 30% of their value in just a few months.
So how do you protect yourself from selling stocks at a loss? Well you can invest in bonds. Bonds tend not to lose as much value as stocks in bad times. In this case it would be wise to hold on to stocks and periodically sell bonds instead.
To recap: In order to live off your investments, you should sell stocks in good times and bonds (or alternative safe investment) in bad times. This will ensure that you are never wiped out.
How much do you need in bonds? Let’s illustrate this with three examples.
Personal situation in bond allocation
Example #1 - Young, single, and debt free
Suppose you meet all three criteria: You’re young with a stable job, which means that you don’t need to worry about your next paycheck. You’re single, so you can easily move to another city or country to find a different job if the going gets rough. And you’re debt free, meaning that you don’t need to set aside large piles of cash to pay for student loans or mortgage debt.
In the example above, you can afford to have only a few months of living expenses in bonds. Coupled with your savings, periodically selling your bonds will provide sufficient income to cover your expenses. This strategy should give you plenty of time to find another job if you lose your job.
Example #2 - Parents with mortgages
Couples with kids and a mortgage may seem to have everything figured out: They have a loving family and they own a home. However there are some financial dangers lurking about. For one, kids need to fed, clothed, and educated. This isn’t always cheap. Additionally, you have to pay off your mortgage every month. Failure to do so may result in the bank seizing your house (and never recuperating your down-payment in the process).
Unlike the young, single, and debt-free income earners, parents with mortgages have a lot of expenses that they simply can’t cut back on if life gets tough.
Additionally: don’t take comfort in the value of your house. Real estate is an illiquid investment that can’t be sold quickly enough to cover your immediate expenses. Even if you do somehow manage to sell your home quickly, you’ll still have to pay taxes, notary fees, and agency fees, which can eat up a sizeable chunk of your capital.
In the example above, parents with mortgages should keep, at the very least, a year’s worth of living expenses in bonds or money market funds. This will ensure that they will never have to sell either their house or stocks at a steep discount to meet their expenses. In this case, bonds will give you one year’s worth of financial room to manoeuvre out of a tough situation.
Example #3 - Financial independence
Whether your debt-free and retired or have just quit your day job to follow your passion, you may no longer have a job that provides you with sufficient income to cover living expenses. As such, you are entirely relying on your investment income.
Once again, it may seem logical to place most of your money in stocks (as they provide superior returns), however this is counter-intuitive. The stock market is irrational in the short to medium term. For this reason, you should be prepared to experience a few recessions and stock market crash during your investing lifetime.
Suppose that the stock market has recently crashed and the value of your stocks has fallen by 30%. In the absence of any cash, savings, or bonds, you will have to sell your stocks at a severe discount to cover your expenses. This may devastate your portfolio.
Remember: We aim to buy low and sell high, not to sell low because we were too greedy and invested everything in stocks.
In this case, we only need as much cash and bonds to keep us going through a stock market crash, but how long do these last?
How long does a stock market crash last?
Well in the pandemic-induced stock market crash of 2020, it only took 6 months for the stock market to recuperate its losses. However this was an exception. It took the market 5 years to recover from the 2007 stock market crash, and 7 years to recover from the 2000 crash (this one is tricky as the stock market crashed immediately after recuperating its losses. In fact, if you invested at the peak of the tech bubble in the year 2000, it would have taken 13 years before you made any significant gains).
The point is: stock markets can remain depressed for years, and you should plan accordingly
Investor profile in asset allocation
So far we have learned four principles of portfolio management:
1. Stocks provide better returns than bonds over the long term;
2. We should avoid selling stocks during a stock market crash;
3. We need bonds to keep us going through rough patches;
4. How much bonds you need depends on your personal situation.
The question now is: Does the last principle change according to investor profile? Let’s quickly recap the differences.
Defensive investors tend to favor security over performance.
Aggressive investors tend to favor performance over stability.
Moderate investors aim for a good mix of both.
Whether you are an aggressive or defensive investor, the data is clear: Stock returns are far superior to bonds over the long term. The academic literature seems to have reached a consensus on the equity to bond allocation: It should never exceed 80/20 in both directions. This means that you should have at least 20% in stocks at all times, even if you are terrified of stocks. By the same token, you should have at least 20% in bonds (or equivalent) at all times, even if they’re not exciting.
So what's the verdict?
Owning stocks and bonds is a must for all investors. The rules of the games are the same for everyone: stocks perform well in good times but lose a lot of value in bad times, hence you should keep enough in bonds to survive the bad times.
As we don’t know how long the next market downturn will last, defensive investors may play it safe by allocating several years’ worth of living expenses to bonds. In this case defensive investors will never be caught on the wrong foot.
In contrast, aggressive investors may keep only one year worth of living expenses in bonds, hoping that either the stock market would have sufficiently recovered by then, or that they would have found a new source of income in that time.
But how much you will really need in bonds is entirely based on luck. Let’s illustrate this with three examples:
Example #1 - The unlucky investor
Suppose that you just invested in stocks yesterday, and the stock market crashes tomorrow. Chances are your stocks lost a lot of their value. In this case you would have been better off to buy bonds.
Of course, you couldn’t have known about the stock market crash, so the best you can do is to buy as much bonds as you would need to survive a bear market.
If you have a steady stream of income from your job (or anywhere else) and no debt, you needn’t worry. Your income will cover your living expenses and you will not need to sell any stocks at a loss. In contrast, if you don’t have any income, you would need to sell bonds to cover your living expenses. The thing is, will you have enough? This bear market could last for years.
If a market downturn happens tomorrow and lasts several years, the defensive investor will be adequately protected while the aggressive investor may be in trouble.
However, if the market downturn only lasts a few months (as was the case in 2020) the aggressive investor will survive. In fact, with a larger stock allocation, the aggressive investor could expect larger gains going forward.
Bottom line: If you invested all your money yesterday, the market crashes tomorrow, and the market stays depressed for years, you would have been better off with bonds. However, this is planning for the worse and is statistically improbable.
Example #2 - The lucky investor
Suppose that you invested in stocks yesterday and the market enjoys a fantastic bull-run for the next 10 years, you would have made great returns. In fact, even if the stock market crashes by 30% in 10 years, chances are you still would have made a lot more money in stocks than if you invested in bonds.
In contrast, the defensive investor who planned for the worse and has placed most of their money in bonds, would have experienced very low returns over the last 10 years.
Bottom line: If the stock market crash only occurs in 10 years, you would be better off investing in stocks today.
Example #3 - The probable scenario
Let’s face it, most of us won’t be lucky enough to be able to invest right after a stock market crash when stock prices are selling at huge discount. It’s also highly unlikely that we would be investing at the height of a bubble right before a stock market crash (it is still a possibility, hence why dollar-cost-averaging should be encouraged).
So what does the data say? Well statistically, the market reaches new all-time highs 2 out of 3 years. We also know that, historically, the stock market goes up like a staircase and down like an elevator.
So chances are we’ll be investing at the top of the market but with still a few more stairs to climb. We also won’t know when the next stock market crash is coming. This is where your risk tolerance comes into play.
An aggressive investor may decide to play the odds and only keep a minimum amount in bonds. This will allow aggressive investor to maximise returns while also keeping enough in bonds to survive a year of bad times.
A defensive investor may decide to play it safe, especially if they’ve got a large mortgage and kids to feed. Nevertheless, if the defensive investor has a stable job that won’t be affected by a market downturn, they can afford a softer bond allocation as income keeps flowing in.
The verdict
As you may notice, the answer to how much bonds you need isn’t as much a percentage based allocation (e.g. 50% bonds 50% stocks) but has more to do about how many months / years / decades of security you need to have in bonds to feel financially secure.
Feel free to play around with the examples above and try to find what works for you.
Try to imagine a situation where you lose 30% of your portfolio in a stock market crash. How will you feel? How will you react? And how much would you need to have in an emergency fund (bonds) to feel sleep soundly at night?
For me this is about 2-3 months of expenses in cash and just over a year’s worth of expenses in bonds. Bear in mind that this will be different for everyone based on your personal situation in terms of planned expenses, debt levels, job security, and expected retirement date.
Bonds & low interest rates - Want to find out if you should swap bonds for another asset class to boost performance?
FAQ
The real risk in investing is the risk of running out of money. Never investing and keeping all your assets in cash is a recipe for disaster: with inflation, you are destined to run-out of money over the long term.
The same goes for bonds. Yes they are less volatile than stocks but they also massively under-perform over the long term. Don’t be seduced by short term stability.
In fact, academics have a term for this: Myopic Loss Aversion
Myopic loss aversion is a condition many investors are afflicted with: some investors are so terrified of the prospect of (temporarily) losing around 30% of their money during a stock market crash that they never invest in stocks.
This leads their portfolio to under-perform over the long-term. Academics have ran the numbers and found that compounding a 3% yearly under-performance will lead to 59% smaller net wealth in 30 years.
In other words, the fear of losing 30% in the short term, leads to a 59% loss over the long term.
Bottom line: Remember that investing is a long-term game and invest a sizable chunk of your portfolio in stocks.
Investing has a clear risk to reward system.
Investments that promises higher returns usually entail much higher risk, and this is no different with bonds.
Most companies or countries that issue bonds will try to pay as little in interest as they can. For this reason, conservatively financed governments (such as Germany) which have a low probability of default can issue debt at extremely low interest rates and people will still buy it (because it’s safe).
In contrast, a struggling company may have difficulty attracting any investors without the promise of higher reward to compensate for higher risk. For this reason, high-yield bonds carry a lot more risk than safer bonds (e.g. short term German government bonds).
Needless to say, holding on to high yield bonds is risky business, and even more so in times of financial stress.
Remember: Your emergency fund is supposed to protect you from a stock market crash. This is why you should favor “safer” short-term government bonds (preferably through a bond ETF).
And don’t worry about their lower performance relative to high-yield bonds, the higher performance of your stocks will easily bridge the difference.