Are Bonds Really Aggressive?

When investors talk about conservative strategies, bonds typically come to mind. However, recent announcements challenge that view. UBS, for example, is increasingly viewing bond investors as aggressive investors. FINRA, the Financial Industry Regulatory Authority, just published an Investor Alert that outlines the risks bond investments face in the event of an interest rate hike. A CNNMoney survey stated that 70% of investment experts expect interest rates to rise within the next two years.

We may be years away from rising interest rates. Nobody knows for sure. That's why you should not invest in prediction, but in preparedness. What does that mean? It means investing in ways that prepare you for different outcomes.

One way to prepare for different scenarios is by diversifying across multiple asset classes. I am not just talking about different types of stocks and bonds. Stocks all count as one asset class. Various research firms, including American Funds, have illustrated how similarly correlated stocks as a whole have performed over the past few decades. (For a more detailed explanation of correlation, view this article.)

Diversifying across multiple asset classes with low to no correlation can lower volatility while offering a chance for higher returns. Why is that? Well, if your investments' values do not go up and down at the same time, you have the chance to sell some investments while prices are high and then use the proceeds to buy other investments while prices are low. Obviously, this strategy only works when you are buying low-priced investments that are temporarily out of favor. If you pick an investment that is not simply experiencing a down cycle, but is a bad investment, buying at low prices may not offer the solution you are looking for. The strategy also assumes that you take a very disciplined approach. That is, you are not making buy and sell decisions based on temporary headlines. (Read this article for more information on why diversification across multiple asset classes can be beneficial.)

Finding low-correlated investments has become more and more challenging--especially when searching among publicly traded investments only. That's one reason why you should also diversify within each asset class. This includes multiple managers in the public and private arena. Each asset class can address different concerns. With bonds, rising interest rates are a concern. If interest rates rise significantly, you don't want to be heavily invested in bonds. But if they don't rise, you may want to have some bonds. Either way, the answer is not to sell all your bonds in fear of rising interest rates. After all, we can't predict what will happen next. But proper diversification can address different outcomes. (Click here to see what investments bode well historically during inflationary times.)

Proper diversification sounds easier than it is. It is time consuming plus takes experience and skill. But it can be rewarding. Even if you consider bonds to be aggressive like some suggest, bonds still have their place in a well-diversified portfolio. But if your portfolio lacks diversification, then it doesn't really matter what you are invested in, your strategy could be classified as aggressive.

The question should not be, "are bonds aggressive?" It should be: "how much exposure do you have to bonds?" The same question can be asked about any other asset class.

If all your investments are in one asset class, it can potentially hurt your portfolio. Even if all your assets are in cash, for example, hyperinflation could wipe out your purchasing power.

So, are bonds aggressive? It all depends on your exposure.