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The Case for Investing in Bonds, Too

Updated: Sep 11, 2014 10:10 PM UTC | Originally published: Sep 19, 2012

Q. I'm 52 and have had 100% of my savings in stocks since I began investing at age 25. Given my high risk tolerance and the fact that I expect that my pension and Social Security to cover a substantial portion of my expenses in retirement, why should I reduce my investment returns by investing in bonds? -- Eric C.

A. If you've been putting your dough exclusively in stocks for the past 27 years, then you know firsthand how lucrative they can be over the long term. Since 1985, the year you began investing, stocks have gained an annualized 11%.

You no doubt also know how risky stocks can be over shorter periods. You've lived through the Crash of 1987 when the Dow Jones Industrial Average plummeted 508 points -- nearly 23% -- in a single day. And you've survived both the bear market of 2000-2002, which saw stock prices fall 49%, and the meltdown of 2007-2009, when stock values dropped almost 57% (a setback from which they still haven't fully recovered).

I'm sure I also don't have to tell you that bonds returned far less than stocks over the past 27 years and that their yields are especially low right now, with 10-year Treasury bonds yielding less than 2% and investment grade corporates paying only a half percentage point or so more.

Given your experience with stocks and the state of the bond market these days, I can understand why you equate keeping any of your savings in bonds as nothing more than an invitation to subpar returns.

But I think you need to revise your thinking. Here's why:

You became an investor near the beginning of one of the greatest bull markets in history. The surge in stock prices that began in 1982 and with few interruptions continued through the end of 1999, showered investors with almost unprecedented rewards. It also included some truly phenomenal stretches, like the 10-year span from 1989 through 1998 when stocks gained a compounded 19% a year, almost double equities' long-term annualized return since 1926. So I think it's fair to say that this outsize performance has a lot to do with the way you feel about stocks.

Related: Investing: When to ‘Take Money off the Table’

What's more, up to now you've viewed the risks and rewards of stock investing primarily through the lens of a relatively young person. Which means you've been much more likely to shrug off stocks' periodic setbacks. They're not as scary when you have decades to rebound from them.

But looking ahead, conditions may be quite different. While stocks are still likely to beat bonds over very long stretches, many analysts believe stocks won't deliver anywhere near the same size gains they did in the go-go '80s and '90s, nor will they outperform bonds by as large a margin.

That's certainly been true for the past 10 years with stocks gaining 7.3% vs. 6.3% for bonds. Some investment advisers, like PIMCO's William Gross, are even forecasting extremely meager stock returns for the years ahead.

And while you may still think of yourself as quite the risk taker, I think you should allow for at least the possibility that a 50% decline in the value of your savings -- and the retirement income it might produce -- may be much more upsetting as you get closer to the end of your career than it was when you were starting out. I'm a bit older than you, but I've found I'm much more sensitive to stocks' volatility myself.

As you weigh the issue of risk, you may also want to factor into your thinking recent research that suggests that the severity of downdrafts we've seen in stocks in the past may occur more frequently than we previously believed.

At any rate, I recommend that you at least consider scaling back your equity exposure. I'm not talking about a total retreat. Rather, I'm suggesting a stocks-bonds mix that allows for long-term growth, but won't get hammered as much should the market tank during your home stretch to retirement -- say, 70% stocks and 30% bonds. As you age, you would then gradually reduce your stock stake, dialing it back to 50% or so of your holdings by the time you retire and then eventually paring it down to between 20% and 30%.

If you expect that your pension and Social Security will cover most of your basic retirement living expenses, you'll have more leeway in how much you'll have to draw from your stock portfolio. That flexibility could allow you to be more aggressive and increase your stock percentage a bit. But I'd be wary of going higher than, say, 75% to 80% stocks today and 55% to 60% at retirement.

Related: Retirement Income: Five Steps to a Sound Plan

Many investors are particularly wary of making bonds part of their portfolio these days for fear they could suffer losses if interest rates rise. But the potential setbacks in bonds -- especially those with short- to intermediate-term maturities -- pale in comparison to the hits stocks have taken in the past and could take in the future. So despite any anxiety about interest rates rising, bonds are still a worthwhile way to reduce the overall risk level of a portfolio.

Bottom line: I'm all for maintaining reasonable exposure to stocks in the years leading up to and following retirement. But the key word is reasonable. Obviously, you have to decide what's appropriate for you. But you'll be a lot better off if your decision includes a realistic reassessment of your risk tolerance rather than simply going with what worked over the past 27 years.