Bonds Can Corral Your Risk

Rainy-day money. Sleep-at-night money. No matter what you call it, you need to put part of your asset allocation in bonds.

"The more nervous my clients are, the higher the bond allocation," says Donald Sowa, financial adviser of the Rhode Island-based Sowa Financial Group. "We let people understand that it will pull down the performance of their portfolio in the long run, but it provides safety."

Safety, as it is often said, comes in numbers. In this case, the most important number is the percentage one allocates to fixed income in his or her portfolio. It's a number that is often difficult for investors to calculate, as they try to balance the value of a good night's sleep with the need to make sure they can generate enough income to retire or to send the kids to college.

Developing an asset-allocation strategy -- read the rest of our series here -- starts with age. The younger you are, the more risk you can afford to take. As you get older and approach retirement, you'll probably be less interested in the growth of your portfolio and more interested in capital preservation -- protecting the value of your portfolio from any declines. Preserving your portfolio as you reach your desired retirement age becomes more important since a large decline in the value of your holdings can affect your retirement lifestyle, or even make it impossible to retire according to your plans.

The typical back-of-the-envelope calculation for allocating an asset mix according to age calls for subtracting your age from 100 and investing the difference in stocks. So if you're 40, the quick math would lead you to an asset allocation of 60% stocks, 40% bonds.

After he checks his clients' vital statistics, Sowa says he puts 20% of his growth-oriented investors' money into actively managed bond funds, which he says are preferable for most clients who don't have the money to buy individual bonds.