Karl writes in to ask,
“The old ‘age in bonds’ rule would have me put approximately one fourth of my portfolio in bonds. But I’m reluctant to put anything in bonds because I’m afraid that bonds (Treasuries especially) are in a bubble much like tech stocks in the late 90s. Assuming the bubble pops and interest rates come back up to more normal levels, bond prices will fall, right?”
It’s true, of course, that interest rates are very low right now. And it’s true that when rates come back up, bond prices will fall.
But Stocks Are Still Riskier
If risk of loss is what you’re concerned about — and saying you’re afraid of a bubble suggests that’s the case — then moving more money into stocks doesn’t make one bit of sense. Even with interest rates at historical lows, stocks are still riskier and more likely to have a large drop in price at any given time.
For example, from its peak in 2007 to its trough in 2009, Vanguard Total Stock Market Index Fund fell approximately 50%. For Vanguard’s Total Bond Market Fund (with an average duration of 5.1 years) to fall by that much, market interest rates would have to increase by almost 10%. In other words, interest rates would not just have to come back up to normal levels, they’d have to go shooting far beyond that.
And if you decided to stick with a short-term bond fund, the risk of significant loss due to a rise in interest rates would be even smaller.
Asset Allocation Based on Risk Tolerance
If the idea of incurring a significant loss in your portfolio really scares you, you need to be thinking about limiting your stock allocation.
My own personal favorite rule of thumb for asset allocation is to spend some time thinking about your maximum tolerable loss, then limit your stock allocation to twice that amount — with the line of thinking being that stocks can (and sometimes do) lose roughly half their value over a relatively short period. For example, if the idea of a 30% decline really scares you, I wouldn’t go higher than 60% stocks.
As far as your bond allocation, if you really are convinced that rates will be increasing soon, using a relatively short-term bond fund will minimize your exposure to interest rate risk.
I’d add the caution, however, that just because rates are low right now doesn’t necessarily mean they’re likely to be increasing any time soon. And by sticking with shorter-term bonds, you’ll be earning a lower rate of interest while you wait for rates to come back up.