balancing-stocks-and-bonds-stillWhen one thinks about portfolio diversification, bonds, in addition to US and International equities should be evaluated.

An investor may be tempted to overlook bonds altogether given that investing in equities tends to lead to higher overall returns. So why include bonds in your investment portfolio? The answer lies in reducing the volatility of your portfolio, providing for short-term cash needs and helping you sleep better at night.

The purpose of allocating a portion on your portfolio to bonds is to reduce overall volatility. There is risk in allocating a large portion of your portfolio towards equities when markets are at high levels. By including bonds in your asset allocation, your overall portfolio risk is reduced given that bonds are not as highly correlated with equity returns and tend to act as a diversifier during market downturns. Additionally, by allocating a portion of your portfolio to bonds, this allow you to have funds in your portfolio available when stock prices are more attractive to increase your stock allocation.

Finally, high quality bonds offer investors something of an emotional hedge against poor behavior. Not every investor is willing or able to have their entire portfolio in the stock market. There’s no use in trying to implement a risky portfolio strategy if periods of poor performance are going to cause you to not stick with it. Bonds can help by providing stability in the event of a stock market sell-off.

Even if bonds were to fall in a down stock market, it wouldn’t be nearly as severe. In this respect, bonds can act as a source of funds for either rebalancing into stocks at lower prices or for selling for cash flow needs. Ultimately, they provide the stability investors crave to alleviate the stress that volatile stock markets can cause.

Source:  Chad Smith, CFP