When you build a 401(k) portfolio, one of the first decisions you will make is choosing how much of your money you want to invest in stocks vs. bonds. The right answer depends on many things, of course, including your experience as an investor, your age, and the investment philosophy you plan on using.
To be sure, you can adjust your portfolio through the years to reflect your needs. But you will need to understand the benefits of mixing bond holdings with stocks and other investments if you are to choose the percentages that best fit your current needs and expectations. Broadly speaking, bonds are more conservative and risk averse than stocks. A bond in the investment world is simply a loan to a company or government money that is paid back in regular payments plus interest.
While stocks represent a partial equity ownership in a company, bonds are debt that the company must pay back. In the event a company goes under, a stock holder’s value will likely to go to zero. Bond holders, on the other hand, will usually have a legal claim to the company’s assets in order to get paid back on the loan they provided.
For this reason, bonds are typically more stable than stocks and have a lower chance of losing money. In fact, mutual funds that hold bonds are often referred to as “fixed income” funds. Although income is not really fixed, and usually not guaranteed, the return streams are more predictable than stocks. All in all, bonds are a great way to preserve capital while continuing to earn money and have an important part in any portfolio. The question remains, then, how much do you allocate to fixed income in a 401(k)?
A sample school of thought that reflects the increasing importance of preserving your savings as you get older and closer to retirement is below. In practice, this approach allocates a percentage representing 110 minus your current age to equities and the remainder to bonds.
Here is what that approach produces for a range of ages:
- 30 Years old- 80% stocks and 20% bonds
- 40 Years old- 70% stocks and 30% bonds
- 50 Years old- 60% stocks and 40% bonds
- 60 Years old- 50% stocks and 50% bonds
To help you better understand the risks and rewards of fixed income in your 401(k) and how to include them in your portfolio, Shelton has prepared a video on bond funds as part of its 401(k) educational library.
Shelton Capital Management has prepared a video on bonds in our educational video library. Check out that video and others on our page, 401(k) Educational Videos