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Rethinking our bond exposure

October 14th, 2008 · 15 Comments

We are in an unprecedented bear market. By the end of last week, the S&P 500 had fallen 47% from its peak. As bear markets go, this already ranks as one of the severest: slightly worse than the previous bear market of 2002 and only bested by a few others. But it is the speed of decline that is stunning. Unlike most other bear markets, which were protracted affairs, stocks have fallen astonishingly fast with the bulk of the declines occurring in the last two months.

It might be an odd thing to say when stocks have been battered and bruised but we may have too much allocated to bonds. As investors with more than two decades to retirement, we hold bonds for only one reason — to lower the volatility of our portfolios. Simply put, bonds help us to sleep better. And bonds have fulfilled that role admirably as stocks have swooned.

As investors pay a high price for the relative “safety” of bonds, which have an expected return that is much less than stocks, the allocation to bonds should be just enough to keep the investor from panicking even in a severe bear market. I was hardly bothered by the rather severe declines recently and slept like a proverbial baby, which might suggest that our allocation of 20% to bonds might be a bit too high and could be trimmed back by say 5%. I haven’t made any changes yet but is something to consider in the future. Unlike the person in Warren Buffett’s colourful depiction who we find is swimming naked when the tide goes out, I’ve been swimming in heavy-duty parkas.

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15 responses so far ↓

  • 1 Million Dollar Journey // Oct 14, 2008 at 7:51 am

    This would be a great time to re balance as you would be purchasing relatively cheap equities.

  • 2 Michael James // Oct 14, 2008 at 8:20 am

    I like the sound of this article, CC. You’re considering a move to the dark side. The water’s fine. Just stay away from margin and you won’t be embarrassed the next time the tide goes out :-)

  • 3 guinness416 // Oct 14, 2008 at 8:29 am

    Pretty interesting post, CC. I like “the allocation to bonds should be just enough to keep the investor from panicking” and will use it with some friends. Personally, I am not bothered much by the drop either (when I avoid the hysterical The End Of The World Is Coming! commentary anyway) and the husband isn’t bothered at all but I’ve always been reluctant to get too far below 25%. Has your wife’s reaction been as sanguine?

  • 4 Canadian Capitalist // Oct 14, 2008 at 9:16 am

    FT: I rebalanced last week.

    Michael: I don’t think I’ll go the whole hog. I’ll just cut back a bit to 15%. The way I see it, the bond component is small enough not to seriously hurt returns. Assuming a 5% expected return from stocks and 2% from bonds, a 15% allocation to bonds reduces returns by about 0.5%. Some of it can be recovered through disciplined rebalancing. I do agree with you on margin — it’s best avoided.

    guinness: It’s a bit difficult to say where someone’s panicking point is. Obviously I underestimated my ability to withstand market drops. But even if I didn’t make any changes, it isn’t a huge issue. We put more in fixed income as we age and even keeping the allocation same will be okay at some point. My wife doesn’t bother much with financial markets — she is oblivious to the market swoon.

  • 5 Dividend Growth Investor // Oct 14, 2008 at 10:22 am

    I have been rebalancing all week last week. As for your allocation would you consider something like selling 1% of your portfolio that is in bonds and buy 1% stocks every month, or do do plan on doing this all at once?

  • 6 Nurseb911 // Oct 14, 2008 at 10:36 am

    Great minds think alike? It seems many investors have considered this topic and further investment into equities while many others have been fearful & running on emotion.

    My moves on Friday look brilliant today, but could be equally foolish tomorrow. 20 years from now I doubt I’ll have any regrets

  • 7 Sampson // Oct 14, 2008 at 11:57 am

    I feel like I’ve been afflicted by a different beast. I have not wanted to increase the bond exposure in our portfolio (currently well below 5%), and I have not been tempted to sell anything. My problem is a willingness to pump the rest of my cash in now.

    The silver lining of all this volatility is that its truly testing my appetite for risk , and we’ll all know our tolerance much better on the other side.

  • 8 Canadian Capitalist // Oct 14, 2008 at 2:24 pm

    DGI: I have to think about the specifics. There are a couple of ways of doing this. I can keep adding savings to stocks or rebalance. I hate to tweak asset allocation frequently, so I’m going to give serious thought to whether I should do this at all.

    Brad: Exactly. I’m all for looking foolish in the short-term and smart in the long-term.

    Sampson: I suppose a close to 50% fall qualifies as one of the worst bear markets. When we survive such markets, we can be pretty sure about our tolerance for risk.

  • 9 B.C. Doc // Oct 14, 2008 at 4:11 pm

    “My moves on Friday look brilliant today, but could be equally foolish tomorrow. 20 years from now I doubt I’ll have any regrets”

    Well said Nurseb911! I’ve been sitting heavy in cash since the beginning of the year– I pulled out of lackluster mutual funds and am currently moving into an all-ETF portfolio. Every time indexes drop 10% or so, I’ve been averaging in. The velocity and depth of this drop is truly amazing!

    My bonds are also holding up well– I’m 20% into bonds. I’m twenty years out from retirement so I will probably drop to 10% bonds as events get even more dire…

    I expect more drop will come. Wall Street hasn’t quite woken up to the fact that its banks have just been partially nationalized with heavy regulation to follow. Nor have stocks priced in the brutal earnings and poor/negative growth which are sure to arrive in upcoming quarters.

  • 10 Forone // Oct 14, 2008 at 6:54 pm

    There are those who would say that the bottom can’t be in so long as you (and the countless others you’re a proxy for) can still sleep, so don’t count chickens. My own relative calm tells me things aren’t scary enough to buy big yet. Bonds may be good for capital gain so long there is a crisis ongoing, but as all the “cures” are inflationary and will take years to work through, the long term prospect is poor. However, there appear to be big discounts in US muni and corporates – assuming this isn’t Armageddon. They’re the only thing I bought Friday.

  • 11 TheProfitMaze // Oct 15, 2008 at 11:02 am

    I am also thinking of changing my RRSP asset allocation (TD index e-funds). I am currently at 20% in bonds and I am considering lowering to 10%. I have 25 years before retirement and now could be a great opportunity for max potential growth on the long term.

  • 12 pan // Oct 15, 2008 at 8:10 pm

    Does anyone use a backtester that they can recommend? Free would be nice. I’d like to try some different allocations.

  • 13 Canadian Capitalist // Oct 15, 2008 at 10:57 pm

    pan: Check out the Stingy Investor’s Asset mix calculator:

    http://www.ndir.com/cgi-bin/downside_adv.cgi

  • 14 A Lap Of The Blogs : WhereDoesAllMyMoneyGo.com // Oct 16, 2008 at 11:05 pm

    [...] Capitalist discusses his personal allocation to fixed income and why he’s thinking of reducing [...]

  • 15 pan // Oct 20, 2008 at 12:14 am

    Thanks for the tip on the asset mix calculator!

    I know that you have discussed the various bond offerings from ishares before, with respect to yield and risk, but is there any easy way to get a (weighted) average rating for the bonds held in any of the bond funds? I’m curious to see just how risky something like XLB is versus XSB.

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