Editor's note: Each week, one of our investing experts answers a reader's question in a Q&A column at our sister site, InvestingAnswers.com. It's all part of our mission to help consumers build and protect their wealth through education. This week's question will be answered by Investment Analyst David Sterman...
Question: When is the best time to buy bonds? And do they still have a place in my portfolio? -- Tracy, Atlanta, Ga.
Answer: Tracy, by the time the stock market crashed in late 2008, many investors had seen enough. Suffering through a second brutal market meltdown in just one decade (after the dot-com implosion of 2001) added up to all pain and no gain. And thanks to a series of scandals related to Bernard Madoff and others, nearly 90% of consumers have come to see the stock market as a rigged game anyway... at least, according to this survey.
Yet despite their misgivings, individual investors are now returning in droves to the stock market. Billions of dollars are flowing back into equity mutual funds, thanks in large part to a brightening outlook for the U.S. economy.
Does that mean that you should follow the crowd and shift your assets out of bonds and into stocks? Yes, you should, unless you are approaching retirement age.
Reason No. 1: Risk equals return
There's a simple, but powerful reason you should favor stocks over bonds. Every asset class delivers a long-term return that is commensurate with the risk it represents. For example, holding cash in a checking account carries virtually no risk, but it earns almost nothing. Bonds offer fairly tepid returns, but if they are backed by a blue chip borrower like the U.S. government or IBM (NYSE: IBM), then they are almost as safe as cash. Yet stocks, which clearly carry short-term risk, tend to deliver superior longer-term returns.
In an ongoing analysis conducted by New York University's Stern School of Business, $140 invested in stocks in 1928 would be worth $167,000 by the end of 2011. About $100 invested in Treasury Bonds would be worth just $6,700. Of course, stocks badly lagged bonds at various intervals, such as in the 1930s and 1970s; but for the most part, stocks have been the winning asset class.
Although we don't know how stocks will fare during the next few years, we have a pretty good idea about bonds: With interest rates already at stunningly low levels, there isn't any room for rates to fall much lower. So bond funds (which rise in value as bond yields fall) have no more room to rally. Moreover, you can find many high-quality stocks that offer dividend yields that are twice as high as current 10-year bond yields.
Reason No. 2: The rule of 100
But that doesn't mean that you should shun bonds. With the "Rule of 100," your base of assets (including stocks, bonds, home equity and other assets) should represent lower risk as you age. Simply subtract your age from 100 to figure out how much exposure you should have to the riskiest asset class -- stocks. For example, if you are 25 years old, then you should have 75% of your assets in stocks. If you are 60 years old, then the percentage devoted to stocks should fall to 40%. The remainder should be tied up in bonds, along with your homeowner's equity.
Reason No. 3: Rainy-day money
Yet there is another factor to consider when it comes to allocating your funds among stocks and bonds. You should never put money into stocks that you may need to tap in the next year or two. Simply put, the stock market is always capable of falling in value in any given year, and as many retirees saw in 2008, their nest egg shrank right at a time when they needed funds for everyday expenses.
As a rule of thumb, determine how much money you would need to live on for the next year if you lost your other sources of income -- and keep that money out of stocks. In this instance, bonds are a perfectly good place to put your excess cash.
Bottom line, you want to look for bond yields that are much more robust than the yields of dividends found on stocks. Right now, the average dividend yield in the S&P 500 is around 2%, roughly in line with the yield on the 10-Year Treasury bill. But because stocks tend to appreciate at a faster pace than bonds, you need to be compensated for the weaker gains in bonds by securing relatively higher yields.
Generally, a bond with yields in excess of 5% should be relatively appealing when compared to stocks. And if yields approach 7% or 8%, as was the case throughout much of the 1970s, then bonds are the better deal -- hands down.
This article originally appeared on InvestingAnswers.com:
Ask The Expert: When Is The Best Time To Buy Bonds?