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Monday, January 30, 2012

Plan Your Bond Allocation

The key (IMHO) to successful investing is to have a well-thought-out plan.  Sometimes the bull will be on the rampage; other times the bear will amble in.  There will be trying times.  On occasion they will be so trying they trigger a "flight or fight" response.  This is when investors without a plan ( I have to say that the Dennis Hopper commercial will forever pop into my head when I talk about investment plans) tend to do exactly the wrong thing.  They throw overboard their investment program just when they should stay the course.  If you have ever participated in a bubble or seriously liquidated after a sharp drop in the market, you know exactly what I'm talking about.

With these considerations in mind, it is worth thinking about your plan for fixed income assets.  I find it ironic that this portion of assets, which is usually considered the "safest," tends to cause the most angst for a lot of investors.  Simply, most investors don't feel comfortable with bonds.  They struggle with the question of whether they should buy individual bonds or funds.  They worry about the impact of rates going higher, and they just feel outright cheated when they contemplate the thought that they could have a negative return when they in effect are lending money to corporations or the government, etc.

The bottom line is that many investors are stymied with this part of their portfolio and, as a result, hold an excess in cash (at practically zero interest) or buy CDs which lock them in at low rates.  Or they take up the laborious task of constructing a laddered portfolio of individual bonds.

I'm not in a position in this post to alleviate all of these concerns with fixed income assets, but I do think it adds perspective to look at a basic ETF bond allocation for the past few years to see one possibility in terms of allocating bond assets.

Returns from iShares
 CLICK TO ENLARGE  The table shows returns for 50% of the assets in the overall market represented by the low-cost Barclay's Aggregate Index (AGG) and the remaining 50% allocated among 5 other sectors.  The other sectors include a short corporate ETF (CSJ), a mortgage ETF (MBB), a high-yield ETF (HYG), an inflation-indexed ETF (TIP), and an emerging countries ETF (EMB).

The right hand column shows the return on the portfolio with the weightings.  In other words, with 50% allocated to the overall market in 2011 and 10% to the other sectors, the return would have been approximately 7.1%.

In normal times (with the 10-year Treasury yield at 5% -6% ), it would be sufficient to just hold the whole position, or at least most of it, in the AGG.  But these aren't normal times - short-term yields are at historically low levels, and most observers see the possibility of a sharp rise in rates sometime in the next 5 years.

In any event, the results show that this simple construction provided exceptional returns - well in excess of what was available in cash and in CDs.  In fact, retirees who achieved similar returns surely were well satisfied.

As always, the allocation for a specific individual will be somewhat different.  The purpose here is just to bring out the actual performance results of a particular allocation that can easily be implemented.  You can play with the returns in the table and add those of other sectors to calculate performance of allocations you would be comfortable with.

Disclosure:  This information is for educational purposes only.  I hold, and my clients hold, some of the ETFs mentioned.  Individuals should do their own research or consult a professional to make investment decisions.


  1. With interest rates left with nowhere to go but up, what is your opinion of buying bonds now?

    The current economic environment is certainly very tricky.

  2. re MC: Bonds are difficult to buy right now but I would allocate assets as indicated above. If the 10 year Treasury yield fell to 1.25% say it would be a big return for bond holders. I'm not saying that will happen but it is possible. Predicting the future of the market is very difficult. The allocation above is a reflection of this.

  3. I'm with you on the plan. It is so important to understand what you truly want to get out of the process; otherwise, you'll always be susceptible to the hype, which is often wrong, or at least too late, to truly capitalize on.

    BTW, I always like following the bond market to a certain extent. It is always interesting what a little bond exposure can do to a portfolio compared to cash or other nonequity near-cash equivalents, as you suggest in the post.

  4. The bond part of the portfolio should be the first thing planned out since it will be the shock absorber for the growth part of the portfolio.