Julia Curbo

Does an Investor Who is Younger than 40 Need Bonds?

We've been seeing some interesting portfolio mixes lately. One young gentleman raved about his "diversified" portfolio and how well he was doing. He had 50% in an S&P index fund, 20% in the tech laden Janus Growth & Income, and 30% in his employers' (also high-tech) stock. This is not what I would call a diversified portfolio. His portfolio is heavily concentrated in large cap, growth stocks (S&P 500 and Janus) and tech stocks.

In response to my question about portfolio diversification, the young man said, "Sure, I know about diversification, but you can't argue against performance."

That's true. You can't argue against performance. But remember, you are positioning your portfolio today for what the market will return tomorrow. I know this sounds clich but it's true. The young man had great performance, but we all must remember that the performance is in the past. It's over. It may happen again; it most likely won't.

Therefore, his portfolio isn't really set up for tomorrow's returns and risks. Sure, he's done fine in a bull market favoring large cap and tech stocks. But, will this continue? Is he adequately diversified if the current trend doesn't continue?

What many people are calling "diversified" today really isn't. A significant number of people are 100% invested in stocks and believe this to be the best bet because they've delivered a higher return on average (when compared to bonds). That is true - stocks have generated a higher return, but in the past.

Just because stocks have outperformed bonds in the past does not guarantee that they will do so in the future. My bet is they most likely will continue to outperform bonds over the long-term. But, you must remember that stocks generally outperform bonds because they are higher-risk investments. When a company generates cash flow, a bondholder is paid before a stockholder. There is inherently less risk from a contract between a bondholder and a company than an expectation of payout of dividends between a company and a common stockholder.

If it is a fact that stocks will generate a higher return in the future, then why is anyone investing in bonds? Are only the smart people investing in stocks and the dumb people investing in bonds?

With less risk in bonds, there are certain periods of time when investors flock to bonds and reduce their stock investments. I am not saying that this is what will happen, but based on history it could happen. Therefore, why not position at least a portion of your portfolio for this event?

Furthermore, there is a widespread belief that stocks are overvalued. There are many arguments that discuss a "New Economy" and why stocks really aren't overvalued. I believe that at least some of this might be true. Having said that, is there still a strong likelihood that stocks will perform the way they have in recent years? A look at history suggests that this is unlikely.

One look at the graph below will show that as the Price to Earnings ratio (a measure of how expensive the stock market is) increases, the ensuing 10 years generate lower returns. When the stock market is expensive and you buy at high prices you guarantee yourself lower performance. When you buy at low prices, you're more likely to generate a higher return.

Therefore, with the stock market at a record P/E ratio, is there really a great reward for completely ignoring bonds? Given their lower risk and the fact that they have outperformed stocks during certain periods of time, I think that bonds should become at least a part of your portfolio.

Julia Curbo manages Portfolios 101, a web site dedicated to portfolio management, personal finance, and retirement planning.