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Why bonds are the most important asset class

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If you want to make the most money, you should invest in stocks. But if you want to keep the money you made in stocks, you should invest in bonds.

It’s ironic, but true: The most important asset class, bonds, is the one that has the lowest expected rate of return. At their core, bonds are quite simple. Yet decade after decade, investors tie themselves in rational and emotional knots trying to deal with bonds.

These days, most people are concerned that interest rates will soon rise. (This has been the case for much of the past 20 years, by the way.) Most investors know that higher interest rates will mean lower bond prices. So how can it make sense to buy bonds now?

Actually, it makes very little sense right now to buy or own bonds in the hope that you’ll be able to sell them later at a higher price.

And that’s exactly the problem that gets investors into trouble. They think that if you can’t sell an investment at a profit, that investment is a bum deal. However, the truth is this: Making a profit isn’t why you should own bonds.

For an analogy, think about an automobile. The reason to own a car is to go places. As everybody knows, that requires an engine. The moneymaking engine in most portfolios is made up of equities.

But would you drive a car that had no brakes? I doubt it. Bonds are like the brakes in a car. The analogy is imperfect, but the point is valid. Like the brakes in a car, bonds let you control the risk of owning equities.

For most people, the reason to own bonds is to mitigate equity losses during major market declines. Without this mitigation (and sometimes even with it), investors tend to panic when stock prices fall.

Instead of considering the possibility of buying more stocks at depressed prices, these skittish investors sell. They usually do so only after they have sustained major losses that they will never recover.

Here’s why you should love bonds: They make the bad times better. Let me show you this with a few numbers.

From 1970 through 2014, a 100% bond portfolio had a compound return of 6.3%. A 100% equity portfolio, widely diversified, had a compound return of 11.8%. Obviously the equity portfolio had a much more powerful moneymaking “engine.”

But the risk or volatility of the bond portfolio, measured in standard deviation, was only 4.1%; the figure for the all-equity portfolio was much less comfortable: 14.8%.

The all-equity portfolio was all engine, without any brakes. Its ultimate long-term returns were great. But without any brakes, that portfolio gave investors such a rough ride that many would have wound up on the sidelines.

The all-bond portfolio, on the other hand, had plenty of safety, but its engine was so weak that it would have failed to meet the long-term needs of many investors.

I said earlier that bonds are for the bad times — when stocks are losing money. The following examples illustrate this.

In the 45 calendar years from 1970 through 2014, the worst years for the diversified all-equity portfolio were 1974 (a loss of 22.6%) and 2008 (a loss of 41.7%). In 1974, bonds were up 6.5%. In 2008, they were up 7.1%.

In a future article I will focus on how much of your portfolio should be in bonds and how much in equities.

For now, let’s look at just those two very challenging calendar years and consider a portfolio that was split 50/50 between stocks and bonds.

In 1974, the loss in the 50/50 portfolio would have been 8.8% instead of 22.6%. In 2008, the loss would have been 19.9% instead of 41.7%.

In those bad years, bonds put on the brakes. And what about the good times? The two very best years for the all-equity portfolio were 1975, when it was up 44.5%, and 2003, when it was up 47.3%. A 50/50 portfolio returned 24.9% in 1975 and 23.3% in 2003.

Both those returns should be perfectly acceptable, in fact quite welcome, for long-term investors.

My recent Performance Series articles have been about how to make more money so you can retire early, take more out during retirement and ultimately leave more for your heirs.

But these articles didn’t focus on the part of the investment process that prevents people from actually getting the returns of what they invest in: Losses, especially big ones, which can happen very quickly.

Peter Lynch and Warren Buffett both have said you shouldn’t invest in equities unless you are willing to lose half your money along the way.

Even though most investors know about this risk, they try to put such unpleasant things out of their minds (often with the encouragement of Wall Street).

When the market goes into a serious decline, many investors panic and wish for safety.

That safety is easily at hand, in the form of bond funds. If you have the right percentage of your portfolio in bonds, you’re much more likely to stay the course. And if you stay the course, you’re much more likely to be in the market when it’s going up.

For more on this topic, check out my podcast: Twelve things investors need to know about bond funds.

Just how much of your portfolio should be in bonds? The answer isn’t always simple. This will be the topic of my next article.

Richard Buck contributed to this article.