NEW YORK (MainStreet) — Waiting to invest in bonds until you are nearly ready to retire will help boost the returns in your retirement portfolio.
Some financial planners and experts advise Gen X and Millennial investors to wait until they only have five to ten years before they retire to purchase bonds.
Many investors don’t need to buy any bonds at all before retirement, said Robert Johnson, a professor of finance at Creighton University’s Heider College of Business. Since life spans are increasing, investors need to ensure they have accumulated enough savings throughout their retirement. A study of Baby Boomers by Allianz Life Insurance Company found that 61% fear outliving their money in retirement more than death.
“Most people saving for retirement wrongly assume that their investment time horizon ends on the day they retire,” he said. “With longer life expectancies and longer time horizons, investors are well served to invest in asset classes that will continue to grow once their retirement begins.”
Maintaining a portfolio that has a large percentage in equities will produce higher returns. Ibbotson and Associates studied returns from different asset classes from 1926 through 2013, and the return advantage of equity securities is well-documented, Johnson said. Large company stocks produced an average mean return of 12.1% while long-term corporate and government bonds had average annual returns about half that of stocks.
“When compounding is taken into account, those return differences are magnified,” he said. “There was a great deal more variability in the returns from stocks than bonds on an annual basis. While the returns from stocks are much higher, the ride can at times be wild. The investor must be disciplined enough to stay with the strategy through the rough times.”
All investors should refrain from investing in bonds, even if they are risk averse and closer to retiring, said Matthew Tuttle, CEO of Tuttle Tactical Management in Stamford, Conn. which has $200 million assets under management.
“I am actually of the opinion that nobody has to buy bonds at all, regardless of age and risk tolerance,” he said. “The decision to buy bonds should be solely made tactically - are they a good investment currently or not. If they are not, then you shouldn't own them regardless of your situation.”
While many investors believe that bonds are a safe haven for their funds, Tuttle says “bonds are not conservative and you can lose money in them.”
“Buying bonds creates a generation of retirees without enough income,” he said.
One misconception is that bonds offer “tremendous protection,” but that philosophy has not proven to be true, said Brian Menickella, managing partner at The Beacon Group of Companies in King of Prussia, Pa., which has $150 million assets under management.
Since equities will always outperform the market and will “always go up,” younger investors who have the resiliency to handle the volatility should avoid fixed income, he said.
“Equities are always hitting new highs,” Menickella said. “Investors should stay in the market and don’t get out. You just have to ride out the lows.”
Although most investors purchase bonds to diversify their portfolio, fixed income, especially bond funds can lose value, he said.
“Equities may be the new flight to safety after interest rates start increasing,” Menickella said. “Money will be flowing out of the bond market into equities.”
While it is important to be diversified, investors do not need to “get too conservative too early” and can wait until they are older to increase their allocation of bonds, said Fatima Izbal, a senior investment strategist for Azzad Asset Management, which is based in Falls Church, Va.
Tolerating market downturns takes discipline, but some investors “fall victim to their own fight or flight instincts,” said Michelle Matson, vice president of Matson Money in Cincinnati, Ohio.
“Market crashes are painful and unpredictable, but the basic rules of investing and academic research show that sticking with a long-term strategy through down markets is a good way to weather the storm and take advantage of downside volatility,” she said.
The largest gains in a portfolio always come from stocks, Matson said.
“Fixed income and bonds are an important stabilizer in a well-diversified portfolio, but the real wealth creation comes from equities,” she said.
Investors in their 20s, 30s and 40s should buy a low-cost S&P 500 index fund and hold onto it, said Johnson.
“It actually doesn’t need to be any more complicated than that,” he said. “One of the biggest mistakes individual investors make is trying to overcomplicate the wealth building process. I would suggest that 80% of investing is simply having a plan and sticking with it.”
To maximize the effects of compounding, investors need to limit large downward swings in the value of their portfolio, said Jason Pfannenstiel, founding partner of Mirador Capital Partners, a Pleasanton, Calif. investment management and wealth advisory firm.
“Bonds should be viewed as an important low volatility component of the portfolio, certainly when compared to the volatility characteristics of most equities,” he said.
Tactical allocation in individual bonds is preferred over bond funds, said Pfannenstiel. Bond investors should consider building a bond ladder consisting of individual bonds, which allow the investor to know exactly what credit quality risk they are taking -- when they will receive income (which is called the coupon) and return of principal (which is known as the maturity).
“Investing in a bond fund carries more risk in that the investor loses control over these important characteristics,” he said. “Gen X-ers and Millenials have one of the biggest assets in investing: time. Compound returns over time are a powerful driver of wealth and savings creation.”
--Written by Ellen Chang for MainStreet