How Much Should You Allocate to Safer Assets?

Stock returns have historically outpaced the returns on other assets, as well as inflation. So, investors might naturally wonder, why hold lower-returning assets at all?

The textbook rationale for holding bonds is that they have historically exhibited a different, lower-volatility performance pattern than stocks and are therefore a way to lower your overall portfolio’s volatility. That can make deciding how much to allocate to bonds seem a bit “black-boxy.”

But I’d say the real-world reason to hold bonds is more commonsensical: to serve as a bulwark of safe assets that you could spend from if your equities go down and stay down for a sustained period. That explains why retirement portfolios for young investors have limited bond exposure—they’re nowhere near needing their money—and why portfolios for older adults have relatively more in fixed-income investments and even cash. For those near-term expenditures, you need to settle for something with lower return potential because stability of principal is your main goal. It’s “return of capital” you’re looking for, not “return on capital,” as the saying goes.

The natural extension of that rationale for holding safer assets is that you can use your anticipated spending needs to help set your allocation to them.

Here are the steps I’d recommend:

1. Audit Your Anticipated Spending Needs and Time Horizon(s)

A good first step in determining your fixed-income allocation’s size and composition is to ask yourself about anticipated portfolio spending: How much will you need, and when will you need it? Morningstar’s Role in Portfolio framework uses 10 years as the line of demarcation to determine whether to be in bonds or equities. Because stocks have landed in the black more than 90% of the time in rolling 10-year periods, investors with spending horizons of at least 10 years could reasonably hold most or all of their portfolios in equities. But because stocks are less reliable over short time horizons and downturns are apt to be more pronounced, that’s where an allocation to safe assets fits in. In the Role in Portfolio framework, all of the fixed-income Morningstar Categories correspond with time horizons of less than 10 years. Similarly, my model in-retirement Bucket portfolios all hold 10 years’ worth of spending in a combination of cash and fixed-income assets.

To use a simple example, if you’re retired and spending roughly $40,000 a year from your portfolio, you’d want to earmark $400,000 of your portfolio for safer assets. In a similar vein, if you’re working and aiming to amass a home down payment in five years, you’d want to hold those assets in something other than stocks.

2. Choose Your Strategy: Individual Bonds or Bond Funds?

Once you’ve established how much to allocate to safer investments in total, the next step is to determine what tools you’ll use for the job: individual fixed-income securities or bond funds/exchange-traded funds?

Buying individual securities—for example, a basket of 10 bonds with one maturing in each of the next 10 years—can help address very specific spending needs and protect that portion of the portfolio against losses, assuming you invest in high-quality bonds whose issuers don’t default. This approach also allows you to lock in a specific yield, whereas bond mutual funds’ yields will ebb and flow based on prevailing market yields. Building a laddered portfolio of Treasury Inflation-Protected Securities is a popular strategy to address retiree spending needs.

Alternatively, you can use mutual funds or ETFs for the job. That approach doesn’t provide the same type of principal protection as buying and holding individual bonds to maturity, but it’s less rigid and can make sense for people with less precise spending goals.

3. Fine-Tune the Suballocations

If you’ve opted for mutual funds or ETFs rather than individual fixed-income securities, the key is to use your spending horizon to guide which types of funds to invest in. Morningstar’s Role in Portfolio framework has recommendations on this front, too—again, based on each category’s likelihood of having positive returns over a given holding period.

For holding periods of less than two years, the framework points to cash instruments like money market funds or high-yield savings accounts, or ultrashort-term bond funds if you don’t mind taking a bit of additional risk. That’s Bucket 1 in my Model Bucket Portfolios. These asset types generally have modest yields and return potential, but they’ll typically hold principal values steady. Certain cash-type instruments, like certificates of deposit and bank savings accounts, are FDIC-insured, while others, like money market mutual funds, are not. My bias is to not gun for extra yield with this portion of the portfolio, but to put the focus on safety instead.

Bonds come into play for time horizons of between two and 10 years. All core fixed-income categories in the Role in Portfolio framework correspond with that time horizon. In my model portfolios, I’ve stairstepped the fixed-income holdings in Bucket 2 (the bond bucket) by expected spending horizon and risk level. Short-term bonds supply spending needs beyond the cash investments, accounting for another three to four years’ worth of spending needs. Intermediate-term bonds can supply cash flow needs for the horizon just beyond that, offering slightly higher yields and long-term return potential in exchange for higher volatility. My model portfolios also include a sleeve of inflation-protected bonds to preserve purchasing power with this portion of the portfolio.

Note that my model portfolios don’t include allocations to long-term bonds. The reason is that the portfolios all comprise mutual funds and ETFs, and long-term bond funds carry substantially higher volatility than intermediate-term bond funds. That can make them difficult to own: Morningstar’s “Mind the Gap” research indicates that long-term bond funds show some of the worst total return/investor return gaps of any category.

In a similar vein, my model portfolios also emphasize high-quality fixed-income investments for Bucket 2. Allocations to lower-quality bond types like high-yield and bank loans, while offering higher yields than high-quality investments, tend to exhibit more sensitivity to the economy and the equity market than higher-quality bonds. Such bonds can supply a bit of extra income to a high-quality bond portfolio, but they’re optional.