Monday, February 7, 2011

Is the Bond Market A Concern?

Lately, I've had more than a handful of clients express worries that the bond market will continue to decline in value. Consequently, many individuals have wondered whether they should sell their bond positions.

When addressing these concerns, I first remind my clients that my goal is not to predict what the markets will do, but to prepare their portfolio for long-term growth regardless of short-term market trends. Then, I point out that we have seen turbulence in the bond markets before, and over the long-term people have been better off maintaining their asset allocation in good times and bad.

In fact, over the last 85 years long-term government bonds have actually decreased in value during 21 calendar years. By comparison, large cap U.S. stocks have decreased in value only 24 times during the same time period, and 7 of those declines occurred during the Great Depression. When considering this, one could argue that bonds and equities are essentially equally likely to suffer a short-term decline. Of course, the difference is the degree of the losses suffered. Large cap stocks worst single-year decline was -43.34% (1931), while bonds largest decline during an individual year was -12.19% (2009).

Clearly, we've seen bonds decrease in value before but level heads still consider them an essential element of an investment account. Why? The answer involves diversification. Of the 21 years since 1926 that bonds suffered losses, only in 5 years did stocks also decline in value. As a result, only in 6 of the 21 years when bonds suffered loses was a portfolio that was 50% stocks and 50% bonds worth less at the end of the year. In fact, in 2009, when bonds suffered their largest loss on record (-12.19%), large cap stocks increased in value by 26.46%. Thus, a 50/50 portfolio actually increased in value by 7.14% that year.

The bottom line is that we've seen bonds suffer setbacks before, but very rarely has turbulence in the bond markets lead to significant declines in diversified portfolios. However, having bonds in your asset mix has constantly reduced volatility during rough times in the equity markets. This trade-off of simply too attractive to pass up.

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