A traditional investing strategy would say your portfolio should get more conservative as you age. You might move away from a portfolio that's 100% stocks and toward something with a larger allocation to bonds.
That makes sense for someone in or near retirement. But if you're someone who's 10 years or more away from retirement, do you really need bonds at all yet?
We know that adding a bond ETF to an all-equity portfolio can help reduce overall volatility. If risk reduction is your biggest concern, that move makes sense. But it also comes at the expense of long-term return potential. Over multiple decades, that could cost a lot of money.
Here's how I'd think about approaching bonds in a portfolio.
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Bonds still solve an important problem
Let's start by looking at the Vanguard Total Bond Market ETF (BND -0.07%). It serves as a good proxy for the entire bond market because it includes investment-grade corporate and government bonds. Right now, it yields around 4.7%.
That makes fixed income a legitimate asset class to consider, and nothing like the zero-interest-rate environment of several years ago. But bonds aren't meant to be an equity alternative. They're meant to provide stability and risk-reducing diversification benefits. For someone in retirement who needs to focus on principal protection more than capital growth, that's important.
But considering that the long-term average annual return for the S&P 500 (^GSPC +0.86%) is 10%, shifting from a 100%/0% stock-bond allocation to a 90%/10% split has consequences. Assuming a 5% annual return for the Vanguard Total Bond Market ETF, that change could cost 0.5% in annual return with little meaningful risk reduction in the process.
And that's with just a 10% shift from stocks to bonds. More than that, and the opportunity lost gets even worse.
NASDAQ: BND
Key Data Points
Here's how and when to consider adding BND
First, I wouldn't use age as a hard cutoff or change date. There are too many wild cards, such as how long you plan to continue working, your income needs, spending plans, current savings, and risk tolerance, to boil everything down to a single point in time.
On the equity side, the Vanguard Total Stock Market ETF (VTI +0.82%) could serve as your portfolio's core. If the volatility of a 100% equity portfolio makes you nervous, then you could consider switching a portion of your portfolio over to the Vanguard Total Bond Market ETF to reduce volatility now.
The latest point where you really want to consider adding bonds could be five to 10 years before retirement. You don't want to risk a 30% bear market hitting your portfolio right before you need to access the money. Reducing downside risk would slowly become the primary consideration at that point.
If you're more than 10 years out, I wouldn't make a strong case for a meaningful allocation to bonds unless your risk tolerance warrants it.
