The best way to determine your bond allocation

Academic investing theory from financial experts like to promote having 30% to 40% of your investments in bond funds. This ensures that a substantial portion of your wealth will have a relatively stable value, while still having a little bit of growth. Like a poncho that can be worn by just about anyone, this investment strategy can be used by anyone. The tradeoff that investment theorists usually down play is that it will take substantially longer to build your wealth, because bonds grow at about the same rate as your expenses. Like any blanket rule–a poncho in this case–the 40% bond rule isn’t appropriate for everyone. However, there is a much more practical approach to choosing how much you should invest in bonds.

Let’s assume that your strategy to reach financial freedom is to build a big enough pile of money which you can spend down until you die–a strategy promoted widely by Wall Street, financial advisors, and academic theorists. (Whether this is a good strategy for you is a discussion for another day.) In this big-pile-of-money strategy, bonds can play a useful part because they can be sold at any time, usually, with LESS loss than stocks. For instance, your car breaks down and you need $20,000 to buy another one, but the stock market has just dipped 30%. Bonds typically drop about half as much during recessions, so in this instance, bonds would be down 15%. Being down 15% isn’t great, but if you need the cash in a pinch, then your bonds will usually retain their pre-recession value better than stocks. To have enough bonds to fund your expenses during market downturns, you need enough invested in bonds to tide you over until your stocks can go back up. This is essentially an emergency fund. Does this emergency bond fund need to cover a year of expenses? Two years? Five years? What ever time period you think a recession could last, that is how much you would need in bonds–plus maybe 15-20% as a buffer.

If you think that you might make a rash decision to sell your investments every time the stock market takes a large dip, then having extra bonds in your portfolio can be a way to prevent you from making detrimental investment decisions. However, if bonds are really just a way to get you through a recession, then at some point, bonds will start holding back your wealth-building efforts. Before you reach for the one-size-fits-all bond poncho that an Ivy League professor hands you, think carefully about whether you would be better off with a well-fitted jacket.

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