At the beginning of 2014, there was a lot of talk about inflation and higher interest rates in the United States. As a result, some investors were reluctant to own bonds in their portfolios. One of the unique qualities about bonds is that their prices move in the opposite direction of interest rates. So, if investors are anticipating higher interest rates, it would seem reasonable they’d be reluctant to own bonds in which prices would drop as interest rates rise.
When many people hold the same view of where the market is going, the market will usually prove them wrong and move in the opposite direction. This is precisely what happened in the bond market this year. If we use the yield on the U.S. Treasury 10-year note as our measure of interest rates, we saw the 10- year interest rate actually moved down from roughly 3 percent in January to a yield of 2.35 percent as of mid-November.
This move lower is instructive for us to understand how important it is to have a balanced portfolio consisting of stocks and bonds, even if it defies expectations. We can never be certain which direction the stock or bond market is going. Having a disciplined investment strategy enables investors to make objective decisions, rather than choices made out of fear or greed.
Why include bonds in your portfolio? Investors can benefit from bonds in their portfolio for three key reasons:
- Safety. When the stock market goes down, an investor needs a safe haven as part of the portfolio.
- Stability. The bond portion of a portfolio will also provide a stabilizing force to reduce the risk of the portfolio value fluctuating too wildly in a volatile market.
- Income. Receiving some fixed payments during a market correction will help to minimize losses when stocks trade lower.
Keep in mind when constructing an investment portfolio that risk and returns should come primarily from the stock part of the portfolio. Your safety and risk management should come from bonds.