Why Own Bonds?

You have heard of the importance of owning a diversified portfolio. For those who do not manage money professionally, the mantra to diversify by investment class is pounded into their heads by the consumer finance media and is rarely questioned.

The reason bonds are included in a balanced portfolio is usually to reduce the overall risk characteristics of a portfolio.  For example, if an investor would be panicked by a short term 20% drop in the value of their holdings as reflected in their monthly statement, then we can add maybe 40% to the bond side, making it likely that a 20% drop in stock prices will only result in a 12% drop for that investors statement (.6 allocation to stocks X .2 short term drop in value). It is not that bonds offer superior returns, it is that bonds sometimes provide better returns than stocks with less volatility.  The same reduction in risk can be achieved by holding cash and money market funds, but historically bonds have outperformed cash.

Yet when markets enter periods of extreme turmoil like 2008 and 2009 the usual correlations of investment returns fly out the window and bonds can tank at the same time stocks tank. And when interest rates rise bond prices will fall.

So my question to you is: Why do you own bonds?  Are you afraid of the temporary drops in stock prices or are you just following the mantra of the popular press?  With interest rates poised to rise would you be better off using cash as a buffer?

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