We all know this rule of thumb. Take your age and that’s how much you should invest with bonds. I’m 40, so I should have 40% of my portfolio in bonds. Are you kidding me? That rule of thumb may have made sense when my life expectancy was 70 years old and safe as church government bonds were offering 6% yields. Not anymore.
Portfolio managers are also in a bind. Do I sell Bell Canada’s stock, which offers a 5% and rising dividend, to buy its bond that offers 3% before taxes, inflation, and the fee that I charge to my clients just for rebalancing sake? Rebalancing should be a mechanical exercise, sell what’s done well and buy what hasn’t, but how can bonds do well offering zero real return?
When being safe doesn’t provide any safety, what should you do?
Let me give you an example. Say a couple is ready to retire and has $1M of investable assets. They need to withdraw $50K a year but want to keep the principle intact. They tell their portfolio manager that they don’t want any stocks. Well, sorry, they have no choice. A basket of high quality government and corporate bonds will get you at best 3% a year. And that is before paying any management fees, taxes on the income, and inflation. To withdraw $50K a year and to keep the principle in place, that couple needs to earn way more than 5% a year. The more that couple has in bonds, the less of a chance they have of meeting their goals.
The answer to what you should do is own more stocks. Everything that you read about owning stocks is true. They are volatile, bad things can happen, you can permanently lose your capital and the list goes on. But the math makes sense. If you own more good stocks than bad ones, your portfolio will go higher over time and your income will increase as well. More good than bad is easier said than done. By owning a diversified portfolio of dividend paying stocks that have a history of rising dividends, which have little debt on their balance sheets and that are valued at 15 times earnings or less will probably get you more good than bad.
Disclosure: Barry Schwartz is 40 years old and owns no bonds in his portfolio.