How can you Maximize the Benefit of Bonds?

October 1, 2012 — Leave a comment

Bonds are an excellent tool for limiting the negative impact of stock declines. This article will help you assess if you have a clear plan in place to make the most of your bonds.

It is common knowledge that bonds are a useful tool for retirees to help with current income given the high volatility of stocks. At the price of slower average growth, you get the peace of mind that your income will be there through the ups and downs of stocks. Let’s assess your use of bonds.

How did you use your bonds in the 2008 decline (choose the closest option)?

  1. As stocks declined, I increased my bond allocation, to increase my financial security, given the uncertainty in the world.
  2. I left my bonds as-is, and limited sales from stocks to amounts necessary for living expenses.
  3. I kept the percentage allocation to bonds fixed.
  4. I used bonds to cover my expenses, and did not make shifts between bonds and stocks.

How does each choice affect your financial security?

  1. As stocks declined, I increased my bond allocation, to increase my financial security, given the uncertainty in the world.

This is an intuitive option that many investors chose. It grows your short-term security in case the decline continues. There are two problems with this choice.

Every sale from stocks at a decline locks in the losses, and hurts your financial security for the rest of your life. Your long-term security is devastated.

A less apparent problem is: You gained no benefit from your bond allocation! The only reason to hold bonds is to avoid realizing losses in your stock portfolio. You did the opposite – not only did you not avoid selling stocks for current income; you accelerated the sales at the worst time.

  1. I left my bonds as-is, and limited sales from stocks to amounts necessary for living expenses.

This is a great improvement that avoids turning the temporary declines into a lifelong devastation. Most of the stock allocation is kept in place to enjoy the recovery.

It still has the problem of selling from stocks to cover living expenses instead of bonds. See the second paragraph in the frame in #1 above.

  1. I kept the percentage allocation to bonds fixed.

This is the disciplined approach according to common knowledge: keeping the allocation to stocks and bonds fixed at all times. It results in selling bonds and reinvesting in stocks after the stocks declined (“buy low”). If you followed this plan in 2008, you can be proud of yourself – you were probably one of the best investors out there.

  1. I used bonds to cover my expenses, and did not make shifts between bonds and stocks.

This approach maximizes the benefits of bonds. The reason to hold bonds is to avoid realizing stock losses. By making a full switch to bond withdrawals during stock declines, you completely avoid realizing stock losses. If you followed this plan in 2008, you are probably a rare investor who optimized the use of his/her bonds.

Conclusion

Whatever your intention for bonds is, make sure that your plan reflects it, and that you follow the plan during the worst declines. If you didn’t protect your interests perfectly, you need to come up with a more adequate plan, or a plan that you have the strength and discipline to follow.

#3 and #4 make good use of bonds, with some benefit to #4, given that it optimizes the use of bonds.

The main problem with a diversified stock portfolio is the risk of depleting it through withdrawals during steep declines. A bond allocation can help you avoid realizing large losses during stock declines. A plan that optimizes this benefit calls for withdrawing strictly from bonds, when and only when, your stock portfolio declines.

Disclosures Including Backtested Performance Data

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Gil Hanoch

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