THE BLOG
10/24/2007 10:39 am ET | Updated May 25, 2011

Smart Advice for the HuffPost Investor

Are bonds really a necessary part of every investor's portfolio?

What is my prediction for the continuation of our aggressive foreign policy and how should investors adjust their portfolios to deal with it?

The markets are tanking, so what's wrong with a savings account in these volatile times?

I deal with these questions in this month's column.

If you would like your questions considered, please add a comment to this blog.

Question from Cognate:

Dan,

I don't understand the recommendation to include bonds in a long-term index fund portfolio (say 10 to 20 years before cashing anything in) and for someone who can tolerate occasional dramatic (say 30%) drops in one's net assets. The expectation is that even a 30% drop will recover over the life of the portfolio.

Bonds prevent the possibility of a total loss (if the whole market crashes to zero) but they also prevent the high returns during the good years.

You are correct that bonds should not be included as a part of every investor's portfolio. Investors who can confidently state that they will not need to access a significant portion of their assets for ten years or more could consider a globally diversified portfolio consisting exclusively of low cost, stock index funds.

However, there are relatively few investors who fall into this category. And even some of those investors may not have the stomach to hold on when the market declines dramatically. For example, in 1973-1974, an all stock portfolio would have lost over 40% of its value. The markets did recover, but many investors panicked and incurred significant losses.

Here is the bottom line: Bonds reduce the long-term returns of an all equity portfolio, but holding them gives investors the staying power to wait out the inevitable downturns in the markets.

Question From January:

I read your advice with appreciation. Maybe that's because my modest mutual fund holdings are already diversified along the lines you suggest--with a bit more in international funds and a recent pull back into a somewhat higher percentage of bonds. All the talk about economic dislocation in the coming year spooks me. Isn't the goal to be able to sleep at night?

My question is, Are we committed economically as well as politically to our pursuit of the warfare state? Hence the chances of cutbacks in military spending, no matter who runs the nation, are unlikely?

Also, are our treasuries held by other countries always payable in dollars?

I could not agree with you more: the goal is to be able to sleep at night.

However, the way to get there is not by trying to predict the unpredictable. This strikes me as counter-productive. When our predictions go wrong, our anxiety will be increased.

There is a better way. Determine your tolerance for risk. You can do this by asking yourself these basic questions:

  • Within how many years do you plan to withdraw at least 20% of your portfolio?
  • What is the worst twelve-month unrealized percentage loss you would tolerate?

The answers to these questions will permit you to structure an appropriate asset allocation that will permit you to "sleep at night."

For example, risk adverse investors might consider a portfolio of low cost, passively managed mutual funds consisting of 65% bonds and 35% stocks. Properly structured, this portfolio has a very low volatility. Over the past 50 years, it has lost money only eight times, and its largest one year loss was 4%. Its 50 year average annualized return was 8.72%.

Similar portfolios can be structured for investors with a greater tolerance for risk.

Question From humanoid:

I have been investing in socially responsible funds for years now and am generally satisfied. However, after reading your advice, none of the funds I invest in were recommended by you. I checked their expense ratios and found them to be over 1%. Should I consider moving my money to other funds with lower expense ratios? The funds are no load and have low fees so I'm not sure if changing would be advantageous.

Also, I have some cash right now sitting in a savings account that pays 5.05%. I'm 56 years old, married, with no children at home. I have a 30 years mortgage and no other debt. Where is the best place financially to put my extra cash?

Everything else being equal, you would be well served by focusing on the funds with the lowest expense ratios. Lows fees correlate directly with higher returns. However, with socially responsible funds, you will want to be sure that the screens used to define what is "socially responsible" are the same for the funds you are considering.

If you have "extra cash", I am assuming that you mean you already have 6-12 months of living expenses in savings and are considering investing this cash.

For my views on how investors should determine their asset allocation and select appropriate investments, please see my blog entitled: "It's So Easy, Your Broker Could Do It!"

You are wise to consider investing your assets. A savings account that pays 5.05% is fine for holding cash you may need short term. However, when you consider the 3% historical rate of inflation, and the taxes (at ordinary income rates) on these earnings, you can see that you are barely breaking even, or possibly losing money in this account.

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