by Billy Funderburk, CFP®, MBA
Recently a client asked me, “Why do you put bonds in my portfolio since they don’t seem to be making any money?” Very good question, one that I will attempt to answer in this article.
The short answer to this question is that bonds (corporate, municipal or treasury) tend to be negatively correlated with the stocks in your portfolio. That is to say, when your stocks go up in value your bonds don’t do as well. Conversely, when your stocks go down in value your bonds tend to do well.
This has the effect of reducing the volatility of your portfolio. More importantly, this tends to reduce the amount of the “drawdown” that your portfolio takes during a downturn.
The older you are and particularly when you are drawing again your portfolio, this becomes very important. The reduced volatility can help you to stay invested at times when you might be tempted to sell out your stock position (generally not a good idea).
When drawing against your portfolio (for instance, when you are retired), a large drawdown can be very hard to make up. The math is not hard to understand. Should you take a 4% withdrawal from your portfolio and inflation is 3%, you have to make a 7% return just to keep your purchasing power on a par. However, when you take a large drawdown, you have to make more than 7% to return your portfolio to its former glory while keeping your purchasing power intact. This is very difficult to do.
So, the moral to this story is that you really don’t want to take a large drawdown when you are drawing against your portfolio.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.