One of the most common nicknames for your retirement portfolio is "nest egg," but in the realm of food metaphors, it might be better to think of it like a holiday feast. So many dishes, so many choices, and to be healthy, you need to pick a properly balanced meal -- but also one that suits your personal tastes. So how should one do that? The answer comes under the heading of "portfolio allocation," and it's the focus of this episode of Motley Fool Answers.
In this segment, hosts Alison Southwick and Robert Brokamp consider an asset class much lauded for safety, but not usually for much else: bonds. What they do have going for them is that usually, when stocks plunge, bonds rise (but not always). They pair also consider the "bread and rolls" portion of your investment meal: cash, Treasury bills, and similarly liquid holdings.
A full transcript follows the video.
This video was recorded on Nov. 20, 2018.
Robert Brokamp: So far we've talked about stocks. Well, what about bonds?
Alison Southwick: What about bonds?
Brokamp: Welcome, ladies and gentlemen to the green bean casserole of your portfolio. Some people love them. Some might say they're even good for you. Others, however, can't stand them. I'm like that!
Southwick: I love green bean casserole! There's no way it's healthy!
Brokamp: Well, the bean part might be.
Southwick: Green beans are barely healthy for you and then you're like, "Cream of mushroom soup! Fried onions! Here's the veg!"
Brokamp: An onion's a vegetable, right? Just like a French fry. So that's bonds for you.
Southwick: That's OK if they don't give you a heart attack. Way to go.
Brokamp: Let's look at the historical returns. Since 1926, intermediate government bonds have returned 5.5% a year. Best year -- 29%! Who knew you could get 29% from bonds in a single year? Worst year was -5%, and there have only been a handful of years when bonds lost out, and obviously that's one of the big benefits.
The problem is bonds are particularly unattractive right now because we're in a rising interest rate environment. When rates go up bonds go down. In fact, this year they're actually down. It's never great. It's particularly bad this year because the S&P 500 is also down. And you buy bonds because you want something to be up in your portfolio when your stocks are down.
In fact, since 1926 there's only been two years when both bonds and stocks lost money. The last time was 1969, so we're actually in the middle of what could be a very unique year. Who knows? Maybe the stock market will recover before the end of the year. Bonds probably won't, because the market expects that the Fed will raise interest rates again at the December meeting. I think we've pretty much locked in the loss for bonds this year.
So, what else can you do if you want to have some money out of the stock market? Well, then we'd come to the rolls of your Thanksgiving meal and that is cash.
Southwick: Ah! Bread.
Brokamp: Bread! Your boring bread stuff, right? Everyone should have some, and you can go with the basic, boring rolls that you buy in bulk at the grocery store. That's like going to your local bank and opening up a regular, old savings account and you're not going to get very much. Or you can put in a little more effort. Make your homemade cornbread. Make your homemade whatever. Bacon-filled croissants or something like that. Basically if you put in a little more effort, you can actually earn more than 2% on cash these days, so I think it's worth doing that.
Looking at the historical returns, we're looking at T-bills, which are short-term Treasuries, and basically an equivalent of cash. Since 1926, T-bills have returned 3.4%. The best year was almost 15%. That was in 1981. The worst, of course, is zero, and that's the great thing about cash. It doesn't lose value.
The overall question, then, is how much should you have in cash and bonds? This really depends. When you look across all target-date funds, it surprisingly doesn't change based on the target retirement date. The allocations for these various types of stocks are pretty much the same whether they expect you're going to retire in five years or 50 years. Obviously, that's different when it comes to how much you're going to have in bonds and cash, because the closer you are to your retirement, you should be playing it safer.
But these funds play it pretty darn safe. For example, for a 2010 fund [so basically anyone who's already retired], overall they recommend that you have 62% of your portfolio in cash and bonds. That's playing it pretty safe. And then it goes down as you get further out. So a 2025 fund has about 40% in cash and bonds, 2040 only 17%, and 2050 only 11.2% in cash and bonds.
For me, the Rule Your Retirement model says you should have 40% out of the stock market if you're retired, 25% out if you're within a decade of retirement, and if you're more than a decade from retirement, 5% is fine. And these days I think that, especially for money you need in the next five years that you want to keep perfectly safe, cash is the way to go, because the bond market is just going to continue to struggle over the next year or two.
Over the long term, if you're just looking for some overall diversification to your portfolio, a diversified low-cost bond fund is perfectly fine. Rates going up is actually good for future returns for bonds over the long term. It just hurts in the short term. At some point bonds will return to their historical average of beating cash by 2%, but that's not going to happen for another couple of years. So for money you need to keep absolutely safe, stick to the rolls. Stick to the cash.