What role are bonds playing in my portfolio?

It has been a great few years to keep money in cash!  High yield savings, money markets, CDs, etc. have all given us strong yields and continue to sit at higher yields than we have received on average over the last 20 years.  However, as you can see on the chart below, there is a strong yield curve right now.  This means that as we move out toward longer term maturities we are getting paid with higher yields.  Long story, short:  Bonds are paying some good yields in our portfolios right now.

However, as inflation has crept back into the picture, we are also seeing the bond movements become more correlated with stock movements.  So, what should we remember when it comes to bonds?

Bonds are the shock absorber in our portfolio.  To illustrate this, see the chart below from J.P. Morgan Asset Management’s Guide to the Markets.  This provides a powerful visualization of exactly what we mean.

Look at the rightmost bars. After a significant 20% drawdown, the pure stock portfolio took, on average, 24 months to recover its previous high. That's a long, uncertain two years. But look at the orange bar: A balanced 60/40 portfolio of stocks and bonds cut that recovery time in more than half, down to just 11 months.

We see the same pattern at other market shock points. At a 15% drawdown, the 60/40 portfolio recovered a month faster than pure stocks. While the 60/40 didn't always recover faster – see the 5% drawdown – the depth and severity of the recovery pain after significant market drops is consistently muted. This is the quantifiable effect of bonds as a diversification buffer. They shorten the time you spend underwater.

But here's where we need to address the second part of our question. Holding bonds in our portfolio comes with a cost. The risk of holding bonds isn't that you’ll lose all your money, but that you will lose potential growth. For younger, growth-stage investors, with decades of time ahead, the greatest risk isn't a market correction. It's the risk of not growing their wealth enough.

Over long periods, stocks have historically outperformed bonds by a wide margin. For an investor in their 20s or 30s, the time they spend ‘underwater’ in a market correction is less critical than the potential missed compounding returns of not being fully invested in growth assets. In an environment with inflation, a low-yielding bond portfolio might even result in a loss of real purchasing power. The "safety" they provide can be an expensive drag on long-term performance. The trade-off is real: more stability today can mean significantly less wealth in 30 years.

Finally, it's worth considering that true diversification isn’t just two dimensional with only stocks and bonds. While core bonds remain a smart piece of our portfolio, modern portfolio construction often looks to supplementary assets.

Alternative investments, like certain real estate strategies, or real assets, like gold and commodities, can offer even lower or different correlations. They are not a replacement for bonds, but they can act as an additional, different kind of diversification engine, helping your portfolio weather a wider range of economic conditions and potentially enhancing overall risk-adjusted returns.

For help with your specific asset allocation, make sure to reach out to us!

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Centered Financial, LLC is a registered investment adviser offering advisory services in the State of California, Utah, Texas and in other jurisdictions where exempted. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. There is no assurance that the techniques, strategies, or investments discussed are suitable for all investors or will yield positive outcomes. To determine which strategies or investment(s) may be appropriate for you, consult your financial adviser prior to investing. Any discussion of strategies related to tax or legal planning is general and is not intended as tax or legal advice. Please consult appropriate tax and legal professionals for recommendations pertaining to your specific situation.