SCOTT REED: Let bonds do their job, but do not go overboard

By Scott Reed

“Buy bonds, they’re safe.” “You can’t get safer than bonds.” “If you hold them to maturity they will always pay back your interest and principal.” “You just saw what happens when you take stock market risk – you get burned. That kind of thing doesn’t happen in the bond market.”
I hear investors say things like this all the time. It especially happens after a big stock market decline when investors are at their most vulnerable. We are creatures of habit, so we do things that don’t make sense, but do make us feel better. We buy an alarm system for the house after we have been robbed. We buy flood insurance after the flood. We start carrying mace in a purse after someone has snatched the purse. That one is kind of funny because if someone steals your purse again, then the thief would have the mace. But you get the point.
Everyone I know believes in buying low and selling high. The problem is that so many of us just aren’t mentally equipped to implement that strategy. When the Dow Jones industrial average dropped to almost 6,400 in Spring 2009, investors had the greatest buying opportunity in a long time in the stock market.
So what did we do? We set records by taking our money out of the stock market and putting it in the bond market. In the heat of the bear market in 2008, Treasury bonds were the best performing of the traditional asset classes. It is the investor’s version of comfort food. Nothing can go wrong if we just buy Treasury bonds.
There is truth to that way of thinking, at least for Treasury bonds. But not so much for other bonds. I know a group that invested 100 percent of its portfolio in bonds. Most of them were corporate bonds, but they were good, high quality corporate bonds, so “what could go wrong?” Unfortunately, some were General Motors bonds, some were AIG bonds, etc. You get the picture. For 2008 the group’s bond portfolio was down more than 40 percent and it could not hold all the bonds to maturity because many of them had gone away completely.

A different problem
Treasury bonds, on the other hand, have a different problem to overcome. Because they are considered by most to be the safest investment in the world, they also pay less than almost anything you can do with your money. That is an issue when inflation rears its ugly head. Inflation is a nasty word for the long-term investor because it just eats away at one’s ability to buy things. Most people I know don’t really care how much money they have; they care about how much they can buy with the money they have. Inflation makes money less valuable and that can be a big problem in the long run.
I love bonds. They aren’t sexy and they don’t make good cocktail chatter. But bonds are solid and you can, for the most part, count on them to do what they need to do. What they need to do is protect you during the bad times (they weren’t so good at that this past bear market) and give you income you can count on. Every single asset allocation model that we have at my firm includes bonds at some level, but they are not the Alpha and Omega of safety as so many investors believe. A portfolio of 100 percent bonds never has been the safest portfolio you can have. If you just look at U.S. stocks and U.S. bonds you would find that the safest portfolio is about 25 percent stocks and 75 percent bonds. That 25 percent allocation to stocks is crucial to the safety of the portfolio, and I have yet to hear a reasonable argument to the contrary.
As you add asset classes those numbers change, but the lesson from this column is that in order to reach your financial goals you must look at your situation with reason and with knowledge. Doing what feels good in any endeavor has its own set of risks. I have yet to find a comfort food that, when consumed in large amounts, will make you healthy.
Scott Reed, CIMA, AIFA, is CEO of Hardy Reed Capital Advisors in Tupelo.