In his annual letter to Berkshire Hathaway shareholders, Warren Buffett, the Oracle of Omaha, gave another warning on the risks of bonds:
"It is a terrible mistake for investors with long-term horizons — among them, pension funds, college endowments and savings-minded individuals — to measure their investment 'risk' by their portfolio’s ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio Increase its risk."
He’s been telling people to beware of bonds for years. But before you bail on bonds, there are a few points to consider.
First, I agree with Buffett that if one is either fabulously wealthy or an institution with the goal to go on forever (such as endowments and pensions), bonds can decrease the likelihood of success. This is especially true of pensions, which are grossly underfunded and must get higher returns to meet their obligations.
I have a finite life span, and being the richest person in the cemetery isn’t my goal. That’s why, at age 60, I have a portfolio that's 55 percent fixed income, composed of bonds and CDs. I live fairly frugally, shopping for deals and buying modest cars and keeping them for a long time. I’ve met my financial goals, and I have enough to live on.
Why, then, does Buffett say high-quality bonds have risk? If interest rates increase, the value of the bonds and bond funds will decline, because those bonds and funds will be paying less than the current interest rate. But before you assume that rates will rise, remember two things.
1) The Federal Reserve controls only the overnight rate. I noted last year that the Fed raised rates and bond rates declined.
2) Economists have an awful track record of predicting intermediate-term bond rates.
In fact, both economists and Buffett have been cautionary about bonds for some time, and I’ve disagreed. Granted, I can’t count on economists always being wrong, so what if rates do rise? Bond funds will decline, but is that such a bad thing? When that happens, yields go up over time as bonds mature and cash flows increase. That’s the silver lining.
With all due respect to Buffett, my advice is, don’t give up on bonds. Stocks are riskier in a day than a high-quality bond fund is in a year. We need only remember Black Monday 30 years ago, when stocks lost over 20 percent of their value in one day, not to mention the two half-off sale stocks have had in the first 18 years of this century. Who can forget the dot-com bubble burst that began in 2000? And the real estate and financial crises that began in 2008? If you are nearing your financial goals, then high-quality bonds reduce risk, since a stock plunge could leave you without enough money to maintain your lifestyle.
It’s during plunges that bonds can provide some comfort to help stay the course. It’s always easier to shun those boring bonds when stocks are near an all-time high, but when stocks plunge, you’ll be glad to have bonds in your portfolio.
Allan Roth is the founder of Wealth Logic, an hourly based financial planning firm in Colorado Springs, Colo. He has taught investing and finance at universities and written for Money magazine, the Wall Street Journal and others. His contributions aren't meant to convey specific investment advice.