A step-by-step guide to build an all weather portfolio including CDs, Bonds, and Bond Funds—even during low interest rates. The goal is a portfolio of stocks and bonds that you can hold for your long-term goals—a portfolio that will survive the inevitable turbulent market periods.
Most investors earn far less than the market. Why? More than half the gap is lost to emotion-driven selling. The rest is lost to expenses.
Step-by-step instructions to build the portfolio that meets your needs
Time needed: 2 hours.
How to build an all weather portfolio including CDs, Bonds, and Bond Funds—even during low interest rates.
- Learn what an all-weather portfolio is.
It is the combination of stocks and bonds (equities and fixed income investments) that you can stick with come hell or high-water.
- For the stocks side, choose broad diversification at lowest possible cost.
Choose a U.S./Foreign allocation that you can stick with: from typically from (10% foreign + 90% U.S.) to (50% foreign + 50% U.S.)
- Learn four reasons why bonds serve an essential purpose in every portfolio.
- For the “bonds side”, consider fixed-income alternatives: what they are; how they work.
- Learn more about risks and returns of owning bonds. Why? You will be tempted by higher yields. Learn the risks first.
- Start with your goals to determine the level of investment risk that is appropriate for you.
* Write down goals that are very likely to still be true for you in 10+ years.
- Use your chosen risk level to determine your allocation to bonds and stocks.
Also, consider your changing needs. Many people gradually increase their bond allocation by around 1% per year.
- Find low cost ways that you will achieve your target allocations.
For stocks, this is always total market index funds. For bonds, it could be a low-cost high-quality bond fund. Or, for some, owning U.S. Treasuries directly.
- Taxes matter. Learn how and when to use tax-advantaged accounts.
Decide which accounts you can and will use.
- Review your plan by comparing with example portfolios.
- Consider a one-fund alternative to see whether it might be a simpler solution. What are Balanced and Target-Date Funds?
- Choose what institution you want to be custodian for your investments.
Companies like Fidelity, Vanguard, and Schwab will help you purchase securities you’ve identified.
- Re-balance every year to stay on plan. Most important: stay the course.
Step 1: What is an All Weather Portfolio?
As you learn how to invest, you’ll discover that your most important decision is the allocation to stocks and bonds in your portfolio. Your goal should be to find a ratio of stocks to bonds in your portfolio that you will stay with no matter what is currently happening in the markets.
You need to build an all-weather portfolio precisely because you cannot predict the future. Nobody can.
Definition: An all weather portfolio is a portfolio that you can stick with regardless of stock-market volatility and depressingly low interest rates. Why would you want to? Because you have correctly chosen the maximum amount of risk that you an tolerate given your plans to use that money. An all-weather portfolio is neither too conservative (i.e. too little growth from too little risk) nor too aggressive (i.e. likely to cause sleepless nights or premature selling).
Who Should Read This?
Read this guide to learn time-proven wisdom about both short- and long-term investing. Maybe you have heard that you should invest in “broadly diversified index funds at the lowest possible cost.” But, what does that mean? Don’t worry. I’m going to show you, and it is not hard. But there is more! Let me show you some of the valuable reasons why it is important to include bonds in your investing.
Protect Your Investments From Yourself
Consider Fred and Chuck. They’ve both been faithfully investing
15% of every paycheck since the year 2000. Fred was aggressive.
He chose to invest 100% in stocks, and he wisely chose a broadly
diversified low-cost index fund. The stock market began to plummet
early in the summer of 2008, and he began worrying. On September
25, presidential candidate John McCain suspended his campaign to
fly to Washington, D.C. to address the ominous financial crisis.
Enough! Fred traded his 100% stock investment for a more balanced
portfolio (60% stocks/40% bonds). It was worth $84,000 that day,
down from a peak of $150,000 early that year. It was an emotion-based
decision that cost him dearly.
Chuck likes things simple. He hates to stress about financial
decisions, so he invested exactly the same amounts on the same days
into that same 60/40 balanced fund. When Fred’s investment was
down 44% in late 2008, Chuck’s was down only 31%. He hung on,
and despite the ever-present drumbeat of bad news in the news, he
never had a bad night’s sleep. His investments were worth $13,000
more than Fred on that sorry day, but have grown to be worth
$25,500 more than Fred today (June 2014)—and the difference is
growing exponentially. This is what you can do! I’ll teach you how
to reduce the risk of letting your emotions ruin your investing.
Reduce Financial Risk For Known Spending Needs
Sam has a story of being lured into carrying too much investment
risk. Growth in the stock market made him think he could retire
comfortably. He looked forward to retiring in 2010 and was going
to invest more conservatively then—since he would no longer have
an income. Meanwhile, he just wanted to grow that nest egg a little
bigger while he could. But the 2008 financial crisis was
accompanied with massive layoffs. He got laid off—down-sized,
involuntarily retired—but his nest egg that was nearly adequate a
year before was now substantially short of meeting his needs. He
tried to get a job for the next two years and eventually just lowered
his standard of living to match what he could now afford. It’s not
what he had wanted.
It’s Your Most Important Investment Decision
Ask yourself this: “What is your most important investment
- Which stock to buy?
- What to buy?
- When to sell?
- Choosing your stock broker?
- How much of your income to save?
- How to allocate your investing between stocks and bonds?
Two of these answers rise to the top. But I assert that only one wins.
Key point: Your allocation between stocks and bonds is your most
important investment decision.
Yep, it’s that important. But don’t worry, I’m going to make it easy
for you. This guide is all about finding and managing that allocation.
Arguably, deciding to live below your means is equally important
since you have to constantly make the lifestyle choice. I like to say:
Key: Saving part of every paycheck is your most important habit.
This guide explains why CDs, bonds, and bond funds have a role in
every investor’s portfolio—even in an environment of exceptionally
low interest rates. It illuminates how to rely on stocks and the
miracle of compound interest to achieve those big long-term goals,
but it is bonds that control risk in short- and medium-term money
and ensure that you will have the amount of money you need when
you need it.
It’s a practical guide. In addition to removing the mysteries, I
identify common misconceptions and attempt to explain simple
truths in plain English. My premise is that most people can, and
should, understand these.
Step 2: Choose broad diversification of U.S. and non-U.S. stocks at lowest possible cost
The “stock side” of an all-weather portfolio is dominated by low-cost total market index funds. If you are not totally convinced of this, I point you to the other must-read guide Smart Investing For Beginners or the free course Common Sense Investing.
For the stocks side of your portfolio, you want broad diversification at the lowest possible cost. In theory, the amount of every business you would own would be proportional to its size—both U.S. stocks and non-U.S. stocks.
This is almost trivially easy by owning one or two total market index funds and I’ll point you to some examples in Steps 10, 11, and 12.
In practice, inefficiencies such as currency exchange rates, keep Americans from owning our full share of international stocks.
Good advice is to choose a portion of non-U.S. stocks to be somewhere between 0% and 50% of the total stocks in your portfolio. I personally choose 2/3 U.S. stocks and 1/3 non-U.S stocks for the simple reason that I can tell at a glance whether that ratio is out of balance.
Key point: The exact allocation you choose is far less important than making a choice and then sticking with it.
Total market index funds typically own stocks proportional to their size (or, technically their “capitalization”) so no thinking is required for this. And these mutual funds enable us to own more than ten thousand (???) different stocks for the bargain price of 0.05% per year—that’s $5.00 per year for every $10,000 you have invested, and they do all the bookkeeping work to manage that!
Step 3: Learn four reasons why bonds serve an essential purpose in every portfolio.
- Stocks are much riskier.
- Bonds make risk more palatable.
- High-quality bonds can be a safe bet.
- Bonds are an attractive diversifier.
Smart investing is not just about which investment will give you the
highest returns—you can always find a higher risk investment that
promises higher expected returns—it’s about selecting levels of
risk/reward that match your various needs.
Our goal is to always safeguard the money we expect to need in the
short-term while achieving growth, in excess of inflation, to create
the future we desire. CDs, bonds, and bond funds—when chosen
correctly—are uniquely well-suited to help us accomplish both.
Four compelling arguments keep them vital for your investment
portfolio: stocks are very risky, bonds make that risk more palatable,
bonds are a safe bet, and bonds are an attractive diversifier.
Stocks and bonds are the two key ingredients for success. Stocks,
yes! But bonds? When I started to write this guide in 2012, almost
all Treasury bonds had a negative yield after expected inflation.
Negative! next we address most pressing question: Why bother
Stocks are risky in the short run, and the long run too!
What if the stock market tanks—right before you need the money?
The first reason why owning some bonds is always important is
because stocks are very risky. If we pay any attention to the news,
then we know they are volatile. Remember Sam from the
Introduction? His story is all too common. It’s easy to accept too
much risk when the market is rising. Here’s a good rule of thumb:
Key point: Stocks could lose 50% or more of their value in any year.
That year could be this year, or the first year after you retire—so
they are risky in the short term and the long term as well.
Investors expect to be compensated with higher returns for carrying
that risk. Over the past two centuries, stocks have returned 7% per
year above inflation—or a real return twice that of bonds.1,2 The
return above inflation is called the “real return” and that’s what
Charts like the one above are called Hypothetical Return on $10,000
invested because they show total return—both growth in price plus
dividends reinvested—and allow you to compare different kinds of
investments. This chart is unusual in that it covers such a long
history and thus requires a logarithmic scale, but it makes a strong
point that, historically, stock returns have been higher than bonds.
But doesn’t this just beg our very question: Why bother with bonds?
One important time is when you can be hurt by short-term volatility.
The ratio of stocks to bonds is the most important lever you have to
control your overall investment risk.
This figure shows both how investors expect greater returns for
increased investment risk and also how they can control the ratio of
stocks to bonds to control their risk exposure. Later in this book we
will learn why most investors want to own 20% to 80% bonds.
Bonds are risky too. Later we’ll see that bond values move opposite
interest rates and sometimes don’t keep up with inflation. But keep
this in perspective! They are an order of magnitude less volatile than
stocks and we’ll learn how these risks can be managed.
Here’s a question for you to consider. Which of these is true?
(1) The longer you own stocks, the safer they become.
(2) The longer you own bonds, the safer they become.
Did you choose “stocks get safer”?
If we use volatility to measure safety, then this one is false. Stocks
remain volatile every day of every year, including the day before
you sell them 40 years from now. But this is an easy mistake to make
because we often hear that “stocks held for decades rarely lose
money.” That’s true too, but not losing the amount you originally
invested becomes less important than not losing the value it grows
to become—and that you come to rely on.
Did you choose “bonds get safer”?
This is correct. These two choices get at a major difference. While
buying stocks is buying ownership in companies—something you
can keep forever—buying a bond is really just loaning your money
for a specific period of time. The longer you own the bond, the closer
you get to the maturity date, at which time you will (hopefully) get
back the full value that you invested. The highest quality bonds are
very safe with no surprises.
Later on we’ll look at CDs, bond funds, and other ways to own
bonds that have some differences to be aware of. But next, we’ll
look at how bonds can provide welcome ballast to stabilize your
portfolio in a bad year.
Bonds make risk more palatable.
Buy high and sell low? Bonds can help prevent that.
We already saw that stocks are both attractive, and risky. A second
reason to own some bonds is to make that stock market risk more
palatable. An allocation to bonds moderates the short-term volatility
I mentioned Fred, in the Introduction, and how he bailed out at the
height of the 2008 financial crisis. It is sometimes hard for others—
when you’re not in their shoes—to imagine doing this. So I’ve
included this next chart showing the total return of the same stock
fund. It is easier to imagine why Fred felt so terrible that he could
not sleep. The value at its peak was fixed in his head. The future
looked like it might get worse—in fact, it did. Fred got out four
months before the bottom.3
Too many panicked after the market tumbled and sold at a loss.
Remember: newspapers, magazines, and television shows all
amplify the hysteria that cause some to sell their stocks. That
emotion-based bad decision might have been prevented if that
investor owned a bigger allotment of high-quality bonds.
Here’s what happened to an equal investment in Treasury bonds
over this same period. It did great, but probably most important is if
it kept that investor from panic selling during a bad year. Bonds give
the risk-averse long-term investor the courage and confidence to
“stay the course” when the market periodically tumbles.
It is healthy to view bonds as the foundation of your portfolio—a
moderating influence on a stock portfolio. Dr. William Bernstein
once surprised me by calling bonds “the underwear in your
portfolio.”4 But, I like that analogy.
We’d never say, “Bonds are the jewelry in your portfolio.” No one
is going to brag about their bonds at a party, although they might
brag about some stock they got lucky with or show off their jewelry.
The full quote by Dr. William Bernstein is “Bonds are the underwear
in your portfolio—unexciting and not much thought about, but
select the wrong pair and you’ll be surprised at just how
uncomfortable you are.” Perfect! Because this section is all about
planning to take as much risk as you comfortably can, after
considering your goals and circumstances, and then sticking with
your plan no matter what happens in the stock market. Dr. Bernstein
made this comment when addressing whether to buy bonds that will
mature in the short term or the long term. But I also like it because
it applies to choosing between high-quality bonds or high-yield
bonds. We’ll get to all that later.
But first, I have asserted that bonds can be a very safe bet. Is that
Bonds can be a safe bet.
The value of bonds goes down when interest rates go up, so how’s that a safe bet?
The third reason why owning some bonds is always important is that bonds can be a safe bet—and by that I mean “no surprises.” With any bond or CD, you loan your money for a specific period of time in exchange for periodic interest payments on specific dates of fixed amounts. And then at the end of the term you get your full investment back. In some cases, this is all guaranteed by the government—that’s pretty safe.
What can go wrong? Well, you can get into trouble by chasing after high-yield bonds from companies with low credit ratings. These are called “junk bonds” and they tend to get in trouble at the same times the stock market does—the very time you most want some stability. You can also have a problem if you lock your money up for a long term and then need it before the bonds mature.
Key point: The strategy I like, is to choose a fund of high-quality bonds that will add stability to your investment portfolio when the stock market plummets.
The thinking behind this strategy is that you’ll get better overall return by taking your investment risk on the stock side of your portfolio.
How is your understanding of risk? Which of these is true?
- If you hold a bond (or a CD) to maturity, you still have interest rate risk.
- U.S. Treasury Bonds, or FDIC-insured CDs, are risk-free investments.
Did you choose “risk-free investments”? This one is false. These do have impeccable credit risk, meaning they will pay you exactly as agreed (all the interest payments and then you’ll get 100% of your invested principal), but they still have interest rate risk. Interest rate risk means the value of your bond changes when interest rates change. All bonds, including all CDs, have interest rate risk, which is why the first fact is true.
Did you choose “still have interest rate risk”? Yes! This is true. But it confounds a lot of people how you can have any risk from changing interest rates if you get all your interest payments and then 100% of your invested principal on the dates promised.
Let’s look at a simple example to help you see this. Suppose you purchase two bonds. The first bond you purchase yields 5%. The next day, bad luck, interest rates rise 1% and you buy a second bond. At 6%, it’s worth $10 more at maturity. That makes Bond 1 instantly worth $9.43 less than what you paid and that grows to the $10 difference at maturity.
Another way to look at it is: you would need to invest $9.43 at the new interest rate to be equal to the $10 additional that the second bond pays.
Yes, all bonds have interest rate risk. So how can that be a safe bet? Because there were no surprises. You got exactly what you expected, and what was promised, when you purchased each of these!
Later, we will show how to choose bonds that will protect yourself from both interest rate changes, and from inflation. But next we’re going to see the important bonus you get because bonds often “ying” when stocks “yang”.
Bonds are an attractive investment diversifier.
Treasury bond returns are uncorrelated with stock returns. What does that mean? And, why is it important?
Our fourth reason why owning bonds is important is that bonds can be an attractive diversifier in your portfolio. Not only do bonds dilute the amount of the portfolio at risk in the stock market, but the portfolio is strengthened. High-quality bonds are poorly correlated with the stock market so the total portfolio earns a better return for any given level of risk.
Key point: Another useful rule of thumb is that everyone should own between 20% and 80% bonds.
This chart shows that a typical portfolio with 60% stocks and 40% bonds doesn’t fall 30% when the stock market falls 50%—rather something significantly less.
This is a magical benefit for you, but first let’s understand the concept. Correlation is a measure of whether stocks and bond prices move together, or independently from each other.
Ideally, we would find two investments that had attractive average returns, but where one had a good year exactly when the other had a bad one. On a scale of -1 to +1, these would be very negative, but unfortunately these only exist in our dreams.
Uncorrelated, or poorly correlated, means they are independent from each other. This is terrific. Things that move in the same direction at the same time are perfectly positively correlated. An example below, with actual market data, illustrates how correlations observed over short time periods is worthless. Long periods, over 20 years, are required to identify trends that have any predictive value.
Now before we get to the magic I’ve promised, we need to introduce one more thing: we need a way to describe the volatility of these returns.
The average annual return is the expected value. It’s useful and valuable, but it doesn’t indicate volatility. So we use this measure called standard deviation to describe the distribution of returns. It simply means that the total return will be within one standard deviation in either direction, roughly 7 out of every 10 years—or in this case within the range from -10% to +30%. Further, it means that the total return will be within two standard deviations for 95 out of every 100 years. Now let’s put it all together.
To illustrate two perfectly correlated funds let’s combine the S&P500 fund from one company with the S&P500 fund from another. Presumably they are perfectly correlated and the combination is a weighted average.
That’s no surprise. But what if they were perfectly negatively correlated (-1)? For another book I made up an example of an umbrella company and a bathing suit company. Each time the weather changed, sales at one company got better and the other company got worse. I used these to illustrate how two risky assets could be combined in a proportion that eliminated volatility altogether. Sadly, negative correlation is near impossible to find.
Here’s the part that is important: adding any asset with anything less than +1 correlation always provides better risk-return opportunities than the individual assets on their own.
For example, here we combine an equal amount of two funds with the same expected return and the same volatility that are completely uncorrelated, meaning the movements are completely independent and unaffected by each other. The standard deviation becomes less than the weighted average. The combination is better than the individual funds on their own. Wow, where do you find an uncorrelated fund like that? The short answer is: bonds. The longer answer includes a warning that the correlation of two assets depends on the time period they are compared.
This chart reveals that only long-term correlations of broad asset classes have any predictive power for our investments in the future. Consider these correlations over three time periods:
• In the three years 2000 – 2002, stock returns went down but bond returns went up.
• Not always. From 2003 to 2006, stocks went up and bonds went up too.
• And in the years 2008-2009, corporate bonds moved in the same direction as stocks, but Treasury bonds moved opposite.
Key point: The only useful correlation information comes from comparing asset classes over long periods of time.
Key point: U.S. Treasury bond returns have almost no correlation with stock returns—adding valuable stability to an investment portfolio. Being uncorrelated (near zero) means their values move independently from each other—but that doesn’t preclude that sometimes they move in the same direction.
It turns out that to own individual stocks is to carry risk that the market does not compensate. These are the company-specific risks, which can be diversified away. And since other investors will, they will not reward any individuals for holding these additional risks.
In theory , adding any asset with less than +1 correlation to a portfolio provides a superior opportunity than any combinations of the existing assets. This leads to the notion of a best mutual fund which is an index fund of all the stocks of the world held in proportion to their capitalization.
You can easily do this and be diversified both economically and politically, with one or two mutual funds chosen such that it is half U.S. stocks and half international stocks. This would be a reasonable decision. If you have a US-based job, you might want to overweight your international stocks to compensate for your “human capital in a U.S. firm.” But, reasons to underweight international stocks might be for expense reasons, or that they are slightly less tax efficient. Bottom line: choose a proportion of international stocks to be 30-50% of your total stocks, and then stick to it.
The portfolio examples in the last chapter of this book illustrate some specific funds to achieve worldwide diversification of the stock side of your portfolio. Now, what about the bond side?
Should you diversify your bonds in the same way? I discuss that later, but here’s a hint: no. Treasuries have the highest credit quality and do not require diversification. Diversifying bonds is quite different than diversifying stocks.
The bond side of your portfolio could be single bond, say a 5-year FDIC-insured CD. Or, it could be several. Also coming up, we’ll talk about diversifying the term of your bonds. Here again the reasons are completely different than with stocks.
To finish our discussion on correlation, would you like to try a harder question? Which of these is true?
- High-yield bonds are less correlated with the stock market than U.S. Treasury bonds.
- Choosing stocks and bonds that are uncorrelated give investors a “free lunch”.
Did you choose “high-yield bonds are less correlated than Treasuries”? It isn’t true. But that’s OK, because I only made a brief comment on this. Junk bonds, or bonds issued by companies with poor credit ratings, are euphemistically called “high yield” bonds and are sold to investors chasing after the highest yield for their bond holdings. These are more positively correlated with the stock market, and often perform poorly at the very time you need their stability.
Did you choose “the free lunch”? This is true. The overall net result is to get more return for the same amount of volatility, or risk. That’s the free lunch. While moving in opposite directions at the same time would be ideal; being uncorrelated, or even poorly correlated, is very good. This is why high-quality bonds are an attractive diversifier.
Next is STEP 4. Learn more about the popular fixed-income alternatives like bonds, and bond funds, and tips about how to use them.
- Money Market funds,
- Certificates of Deposit,
- Individual bonds,
- Bond ladders,
- Bond Funds