Lifestage Investing: Are Bonds Right for Young People?
This is a question without a simply yes or no answer. A large percentage of financial literature will insist that bonds are completely inappropriate for young people, but that isn’t always the case. In reality, determining whether bonds are right for you depends on your personal situation and what you intend to use the money for in the future.
Bonds as a Short-Term Investment
Conservative bond investments are absolutely appropriate for a young investor who intends to use the money within a short time period – usually the next one to three years.
Here’s why: even though stocks have delivered better returns than bonds over the long-term, they also tend to experience a much higher degree of short-term risk. As a result, an investor who puts $5000 in the stock market today could easily find that their account has decreased in value a year later – meaning that the money won’t be there to pay the bill as intended.
Stocks are therefore not an appropriate investment for someone who needs the money for a particular purpose within a short time period; for example, graduate school, buying a car, or putting a down payment on a house. In this case, the investor would want to focus on a lower-risk bond fund or exchange-traded fund. The returns may be lower, but so are the risks – and in some cases, that’s the most important consideration.
Investing with a Longer-Term Goal in Mind
On the other hand, for a young person who is saving for a longer-term goal – such as retirement or a major purchase that is ten or more years away – stocks are more likely to provide capital appreciation than more conservative fixed-income investments. In this case, the young investor is making the common mistake of not taking enough risk.
Simply put, fear of short-term loss may save you some pain now, but the longer your investment horizon, the more likely you are to cost yourself potential gains down the road. See more about the most common mistakes by bond investors.
The Role of High Yield and Emerging Market Bonds
Does this mean that bonds have no role whatsoever for the young, long-term investor? Absolutely not. In fact, two segments of the bond market – high yield and emerging market bonds – are similar to stocks in that they have higher short-term risk but carry the potential for strong long-term returns.
Consider that in the ten years ended March 31, 2013, the average annual return of the S&P 500 stock index was 8.53%, while the Credit Suisse High Yield Index averaged a gain of 9.83%. During the same time period, the JP Morgan EMI Global Diversified Index – a measure of emerging market bonds’ performance – was ahead 10.21% per year on average. It’s true what they say: past performance is no guarantee of future results. However, these performance results show that high yield and emerging market bonds can provide competitive returns with stocks, and – perhaps even more important – they also add an element of portfolio diversification.
The Bottom Line
Don’t believe any advice which suggests that young people should avoid bonds altogether. Bonds can in fact play a critical role for those with short-term time horizons. What’s more, the blanket term “bonds” fails to account for the potential long-term return opportunities in the higher-risk areas of the bond market. Keep this in mind as you try to determine the most appropriate way to allocate your investment portfolio.
Learn more: Why invest in bonds?