Why it’s wise to add bonds to your portfolio

You grew your portfolio balance big enough now that it’s paying you more yearly than you are earning at your job… Big congrats!!! You have achieved something very incredible! Can you smell that?? That’s the smell of financial independence… What to do next..? Whatever you want to do. Because luckily for you, frugality has kept your expenses lower than your income, (hopefully for some time now, helping you grow your portfolio large enough to retire, or just for the peace of mind.) Let’s say you chose the first of the two.. and have decided to retire. Since there is no longer an income, we must add bonds to the mix. 25 Percent of your portfolio should be allocated to VBTLX, a total bond market index fund.

Few reasons to add bonds to your portfolio.

1. To act as a replacement for your income

Your portfolio is large enough to replace your income. If you happen to decide to solely live off of your portfolio then this is a great time to add bonds (VBTLX, vanguard total bond market index fund) to your portfolio. Bonds can act as a replacement for your income because your holdings in bonds will have a yearly yield while also not fluctuating in price dramatically. Like cash but slightly better. One example of bonds being used as a replacement for your income would be if stocks have a dramatic fall in prices, one would then sell their bonds and purchase stock shares, keeping the 75/25 allocation in tact. Considering there is no longer an active income, this selloff of bonds to purchase stocks would be as if there was an income. Once stocks increase in price, selloff of stocks to purchase bonds again keeping the 75/25 allocation would be a good choice.

2. Protect against large market corrections and flexibility based on age.

This gives flexibility to different investors that may want to smoothen out their portfolios ups and downs. More aggressive or younger investors may want to be 100% stocks as this will average a higher return in their portfolio growth phase. Older or more risk averse investors may want to keep a stable lower return. As we get older, say our 60s or 70s, we wont have as much time as a 25 year old will and that’s just the cycle of life. When we are nearing the end of our lives, say our last 10-20 years.. maybe we dont want to see stocks crash 40 percent causing our portfolio to drop significantly in value. Some investors may even have an allocation of 50/50 stocks and bonds allocation. They may also withdraw a bit more with this allocation mix. The sad truth is, as investors living full time off of a portfolio, knowing how much to spend or withdraw based on our age will be a choice every individual investor will have to make based on their personal lifestyle and time left on earth… Allocation mix is based solely on the investor but I recommend 75/25.

Example of market correction with 100% stocks and also a 75/25 allocation

Example 1: 100% stocks, Let’s just say your portfolio size is sitting at around $3,000,000, market drops 25% one year and now your portfolio is down $750,000 down to $2,250,000. OUCH!!!! That would hurt if that 3 million was in 100% stocks.

Example 2: 75% stocks and 25% bonds. 2,250,000 VTSAX and 750,000 VBTLX. Market then drops 25% like in the first example. This portfolio with the 75/25 allocation mix is now sitting $1,687,500 VTSAX and $750,000 VBTLX. Total portfolio size is $2,437,500. Almost $200,000 more in the 75/25 allocation. This allocation is actually now 56.25/43.75 considering stocks dropped 25% in price. In this case we sell 18.75% of our bonds to then purchase stocks. (18.75% x $750,000=$140,625) Sell $140,625 of VBTLX and purchase VTSAX shares with that capital and now the allocation is 75/25 again. $1,828,125 stocks and $609,375 bonds . When you see a 30 percent gain then sell your stocks and purchase bonds to keep allocation in tact. Reallocation should be done if market is down or up substantially only. In another example if the market is up 40 percent, we can do the reallocation as well. This prepares us for market corrections and throughout years we can keep increasing our shares.

3. Sanity (very important when market drops 20, 30 or even 40 percent..)

Sanity is another good reason, I believe mental health is important and having all your money tied into stocks, then seeing a large correction may cause some emotional damage. Haha. Like I said previously, bonds can help smoothen this out and allow for a more calm, easy going portfolio. Smaller returns of course.. but more stable.