Eh, close enough.

Eh, close enough.

In the world of portfolio management, it’s commonly recommended that an investor needs to own bonds.

The usual formula is pretty simple, chances are you’ve seen it before. You take an investor’s age minus 100 or 110, and dedicate that percentage of portfolio to bonds. So a 60-year old would be approximately half bonds and half equities, while a 30-year old would be between 20-30% bonds.

But there are a lot of investors who don’t heed this advice, for a number of reasons. They might be an uppity millennial, always BREAKING THE RULES and just trying their own crap. Hey man, says the millennial, I don’t need no stinking advice from a SQUARE, MAN. I’m going to go 100% equities because I’m a CERTIFIED BADASS, YO.

Damn millenials. SMH.

There’s another group of folks who refuse to add bonds to their portfolios, and that’s a lot of dividend growth investors. These investors seem to think they don’t need the income bonds generate because they’re getting constantly rising dividends. And since the group’s favorite dividend growth stocks are somewhat conservative in nature, the dividend growth investor figures he won’t see much in volatility during the next market crisis. When stocks go down, folks rush to Coca-Cola and Proctor and Gamble for the perceived security, which insulates them from some of the capital losses, at least compared to Facebook or Tesla shares.

These investors are also convinced that ultra-low interest rates mean the next few years will be terrible for bonds. Rates will increase, which will push the price of the debt down, leading to lackluster returns. I don’t buy it, for several reasons. Suffice to say that the people who predicted the demise in bonds have been doing so for years with very little in success.

Portfolio theory works like this. During times of hardship for stocks, investors rush into bonds. This then causes the value of bonds to go up, which offsets some of the losses compared to stocks. These two asset classes work together to smooth out returns. Essentially, investors give up some potential upside during good times for less in downside during bad times.

For most investors, this is a good thing. Think back to 2008, when stocks were down 30-40% in the year. But if you would have had a healthy bond component (which actually went up in 2008), you’d be looking at a loss of between 20-30%, depending on how much you had in bonds. That’s a much better result for the vast majority of investors who cannot psychologically handle a year where they’re down 40%.

But smoothing out returns isn’t the only reason why you need to own bonds. In fact, owning bonds could be the key to you outperforming the market over time, and all without having to spend hours of your time picking and choosing individual stocks.

Why you need to own bonds

Assume you’re a 30-year old investor with $100,000 stashed away. You have a 70% equity and 30% bond portfolio.

Say the stock market falls 25% one year, while the bond market gains 5%. Suddenly your $70,000 equity position is only worth $52,500, while your bond portfolio is worth $31,500. Total worth is $84,000, which means you just lost 16% instead of 25%. So far, bonds are doing their job.

But now you’re left with a conundrum. Stocks have fallen 25%, which just about guarantees they’re undervalued. You have only $10,000 in new money to invest, which is your TFSA contribution for the year. You’d like the opportunity to invest more money into undervalued stocks, but don’t have the capital.

But wait, you do have the capital. You have a bond component that has increased in value during this whole meltdown. If you sold half of your bonds to put into stocks, you’re practically guaranteed to outperform the market over time by buying more of a beaten-down asset.

Then what you do in subsequent years is buy bonds with those contributions to get the portfolio asset allocation back to the desired levels. And in theory, bonds will be cheaper during those years, since the market will have recovered and investors will be more attracted to stocks. You’ll be putting money in bonds during the right time.

Andrew Hallam (author of The Millionaire Teacher) advocates a very similar approach. Say you own three ETFs — one Canadian equity, one international equity, and one bond fund, all with a 33% weighting. Each year, when you contribute your cash into the investment, just put it into the asset that underperformed. It’s the same sort of deal I just talked about, but even simpler.

How do I know when to sell bonds?

As the expression goes, you gotta be buying when there’s blood on the streets.

Many investors think they’ll know a good buying opportunity when the time comes. If 2008 taught us anything, it’s that most investors are likely to get paralyzed with fear when the market truly corrects.

When I buy an individual stock, I like to set a selling price before I even plunk down my cash in the first place. This makes me more disciplined and less greedy when the time comes to exit. I’m also ensuring I make the decision when I’m calm, and not in the heat of the moment.

It’s the same thing when deciding to sell bonds. Say you think a 20% haircut in the value of the S&P 500 would represent a good buying opportunity. So you set the rule now, when you’re calmly thinking about it. It’ll be hard to pull the trigger when it hits that magical number. Everything in your being will be telling you not to hit that buy button.

Bonds are great for minimizing a portfolio’s loss. But they’re also nice to have as a cash substitute when markets really sell off. That’s the real reason why you need to own bonds.

Tell everyone, yo!