When it comes to investing, a traditional strategy suggests that a portfolio should become more conservative as an individual ages, with a larger allocation to bonds. However, for those 10 years or more away from retirement, the necessity of bonds in a portfolio is a topic of debate.
Reducing Volatility with Bond ETFs
One of the primary reasons to consider adding bond ETFs to a portfolio is to reduce overall volatility. By including a bond ETF in an all-equity portfolio, investors can mitigate the risk of significant losses during market downturns. The Vanguard Total Bond Market ETF (NASDAQ: BND) serves as a good proxy for the entire bond market, including investment-grade corporate and government bonds. Currently, it yields around 4.7%, making fixed income a legitimate asset class to consider.
However, adding bond ETFs to a portfolio also comes at the expense of long-term return potential. Over multiple decades, this could result in a significant opportunity cost. For example, shifting from a 100%/0% stock-bond allocation to a 90%/10% split could cost 0.5% in annual return, assuming a 5% annual return for the Vanguard Total Bond Market ETF. This is with little meaningful risk reduction in the process.
Opportunity Cost of Adding Bonds
The opportunity cost of adding bonds to a portfolio is a crucial consideration. While bonds can provide stability and risk-reducing diversification benefits, they are not a necessary component of a portfolio for those 10 years or more away from retirement. In fact, adding bonds to a portfolio can result in a significant opportunity cost, particularly if the investor is more than 10 years out from retirement.
For instance, if an investor shifts from a 100%/0% stock-bond allocation to a 90%/10% split, they could lose 0.5% in annual return, assuming a 5% annual return for the Vanguard Total Bond Market ETF. This is with little meaningful risk reduction in the process. The opportunity cost of adding bonds to a portfolio is a critical consideration that investors should take into account when making investment decisions.
Considering Individual Circumstances
Rather than relying on a hard cutoff or change date, such as age 50, investors should consider their individual circumstances when deciding whether to add bond ETFs to their portfolio. This includes factors such as:
How long they plan to continue working
Their income needs and spending plans
Current savings and risk tolerance
By considering these individual circumstances, investors can make informed investment decisions that align with their financial goals and risk tolerance.
When to Consider Adding Bonds
The latest point where investors may want to consider adding bonds to their portfolio is five to 10 years before retirement. This is to reduce the risk of a 30% bear market hitting their portfolio right before they need to access the money. Reducing downside risk would slowly become the primary consideration at this point.
For those more than 10 years out from retirement, adding bonds to a portfolio may not be necessary unless the investor's risk tolerance warrants it. In such cases, investors should carefully consider their individual circumstances and weigh the opportunity cost of adding bonds before making a decision.
Conclusion
In conclusion, while bond ETFs can provide stability and risk-reducing diversification benefits, they are not a necessary component of a portfolio for those 10 years or more away from retirement. Investors should consider their individual circumstances and weigh the opportunity cost of adding bonds before making a decision. By doing so, they can make informed investment choices that align with their financial goals and risk tolerance.
