Portfolio construction begins with the most basic allocation between investments that offer a greater chance of appreciation (stocks) and those that provide portfolio stability (bonds). There is no such thing as a safe investment that pays market rates of return.
We recommend that those in retirement have 5-7 years worth of safe spending in stability (bonds). The rest of the portfolio, with a time horizon of 8 years or more, we recommend putting in appreciation (stocks). The balance is between sleeping well tonight and eating well in ten years.
Families who are not withdrawing from their portfolio can afford any asset allocation. They might have a pension which is sufficient for their needs. If they put the entire amount in stocks they can afford the markets bouncing down. It won’t change how they eat. If they put the entire amount in bonds they don’t even need to keep up with inflation.
Here is a nice list of some of the strategic advantages of benefits of holding bonds from Russell D. Francis of Portland Fixed Income Specialists in an article entitled “Investment Strategies” [for bonds]:
Investors may hold fixed income securities for a variety of reasons—for example, to reduce portfolio volatility, generate income, maintain liquidity, pursue higher returns, or meet a future funding obligation. Each objective may involve a different portfolio approach, or a combination of strategies to manage trade-offs.
Stocks and most investments are speculative because the returns on them are not predictable. With high quality individual bonds, however, we can design a portfolio that provides a consistent, predictable cash flow. This strategy enables you to pursue your interests and dreams instead of losing sleep over daily fluctuations in the stock market.
Individual bonds are predictable; they pay a predictable interest and they offer a steady cash flow. Every year they are one year shorter and closer to returning your principal. You can build fixed income portfolios that generate immediate or deferred income based on your current and future income needs.
Protect the principal
Bonds enable you to select the quality that best matches your risk tolerance. CDs are protected by the FDIC. Treasuries are backed by the full faith and credit of the U.S. treasury. Furthermore, defaults on investment grade bonds are historically rare–for both municipal and corporate bonds.
Often lost in portfolio design is the drag that taxes can take on wealth creation. Higher yielding taxable bonds and other taxable investments should he held in tax-deferred accounts, while tax-free municipal bonds should be used in taxable accounts.
Realize capital gain and losses
If rates have declined and a bond has appreciated in value, it may make sense to sell it before maturity and take the gain rather than continue to collect the interest. This decision should be made carefully, however, as the proceeds of the transaction may have to be reinvested at lower interest rates. On the other hand, selling an investment at a loss can be a strategy for offsetting the tax impact of investment gains. Bond swapping can help to achieve a tax goal without changing the basic profile of your portfolio.
Save for a definite future goal
Zero coupon bonds can be used to save for a future goal such as college, a new home, or eventual retirement.
Many risks can be minimized by diversifying a bond portfolio using different types of bonds to avoid regional concentration. Interest rate risk can be minimized by lowering bond duration and building ladders of different maturities. Default risk can be minimized by purchasing high quality (AAA/Aaa) investment grade bonds.