Are bonds only for scaredy cats?

@Money February 29, 2012: 9:37 AM ET

NEW YORK (CNNMoney) -- If you're investing for retirement that is still more than 20 years away and you do not have inclination to sell when stocks take a dive, is there any advantage to owning bonds at all? Or are bonds only for scaredy cats who will sell their stocks during a market plunge? -- Tom McCarthy, Wilmington, Delaware

It's easy for long-term investors like you to think bonds are nothing more than a drag on returns and undeserving of a place in your portfolio.

After all, if you check out "Ibbotson Associates' Classic Yearbook," a compendium of stock, bond and Treasury bill returns since 1926, you'll find that stocks have not only outperformed bonds over the past 86 years -- earning an annualized return of 9.8% vs. 5.4% -- they've also beaten bonds much more often than not over rolling periods of five, 10 and 20 or more years within that span.

But I wouldn't say that there's no advantage to owning bonds. Nor would I recommend that an investor, even one in it for the long term, invest only in stocks. While history shows what happened before, it doesn't predict how things will play out in the future.

True, stocks have beaten the pants off bonds in the past. And I fully expect stocks to continue to do so over long periods in the future. But I'm not convinced enough to make an all-or-nothing bet on stocks. When dealing with uncertainty (and your retirement money), it's prudent to hedge your bets.

There's another compelling reason for long-term investors to own bonds. As impressive as stocks' gains have been, they've come with quite a bit of drama.

From March 2000 to October 2002, the Standard & Poor's 500 index dropped almost 50%. It no sooner recovered when it fell again, this time by nearly 60% from October 2007 to March 2009. Over the 10-year stretch from 1999 through the end of 2008, stocks posted a negative 1.4% annualized return.

I mention these figures for two reasons. One is to prevent you from committing what Stanford professor Sam Savage calls the "flaw of averages" or the fallacy of using single numbers to represent uncertain outcomes. By focusing on stocks' long-term annualized gains, you may overlook how far they have fallen and how long they've remained depressed en route to those gains.

The other reason is that even though you think you're in for the long-haul now -- when the Dow has been on a roll -- it's been my experience that most investors feel differently when things fall apart.

People get very upset when they see the value of their retirement savings drop by half -- or more, as investors in the technology-heavy Nasdaq stock index discovered when it plummeted almost 75% from the beginning of 2000 through mid-2002. (To this day, Nasdaq is still 35% or so below its peak nearly 10 years ago.)

Even the most steady-nerved investors can end up panicking like scaredy cats during major market crises and find themselves fleeing the stocks they swore they'd stick with.

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And even if you do manage to resist the urge to bail during periods of upheaval, you'll find that it's no picnic waiting until the money you invested at the top of the market slowly crawls its way back to even.

Finally, it's not as if stocks' long-term gains are guaranteed even if you do hang in there. Stocks are capable of generating a range of returns. When you invest in stocks, you shouldn't assume you're going to earn a given return. Rather, you should think in terms of probabilities, with your chances of earning returns at the top of the range lower than your odds of earning those at or below the middle of the range.

The same goes for bonds, except that the range of potential returns isn't as wide because they're not as volatile.

By adding bonds, you do reduce your potential upside. But because bond values don't drop as steeply as stocks, you also reduce your potential downside. So mixing some bonds into your portfolio softens the ups and downs and narrows the range of future outcomes. Or to put it another way, it gives you a better idea of how much money you may end up with, although it by no means is a guarantee.

For a look at just how much adding different amounts of bonds to an all-stock portfolio might limit the potential upside and buffer you from the downside, you can check out Morningstar's Asset Allocator tool.

I'm all for investing fairly aggressively when you're young and have decades until retirement. But I also think it's important not to overdo it. I don't like the idea of all-stock portfolios, if for no other reason than it's generally a good idea to hedge your bets -- at least a bit.

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