There are lots of bits of conventional financial wisdom that won't always serve you well. For example, many people recommend buying a home instead of renting, but that's not everyone's best route due to closing costs, homeownership expenses such as property taxes and maintenance, and occasionally, overvalued real estate markets.
Similarly, many have long recommended keeping 60% of your portfolio in stocks and 40% in bonds to reduce risk through diversification. That might not be best, though. Here's a closer look at the issue and the asset-allocation strategy that might be better for you.
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Stocks outperform bonds
A key thing to understand is that stocks generally outperform bonds over most long periods (and many short periods) -- by a lot. Check out this data from Wharton Business School professor Jeremy Siegel, who has calculated the average returns for stocks, bonds, bills, gold, and the dollar between 1802 and 2012:
| Asset Class | Annualized Nominal Return |
|---|---|
| Stocks | 8.1% |
| Bonds | 5.1% |
| Bills | 4.2% |
| Gold | 2.1% |
| U.S. Dollar | 1.4% |
Source: Stocks for the Long Run, by Jeremy Siegel.
The annualized rate for stocks from 1926 to 2012 -- a period you might find more relevant to your life -- was 9.6%, by the way, versus 5.7% for long-term government bonds. Indeed, Siegel's data shows stocks outperforming bonds in 96% of all 20-year holding periods between 1871 and 2012 and in 99% of all 30-year holding periods.
The current economic environment matters
Despite the better performance of stocks, there are times when the stock market will slump, and sometimes it will remain slumped for longer than you'd like. Bonds are one way to try to offset that, because many times, bond prices will rise when stocks fall, and vice versa.
If you're wondering why that is, think of interest rates. High rates can make it hard for businesses to borrow money, grow, and prosper, making stocks a bit less appealing. (Bank stocks, though, tend to do well with rising rates.) Rising rates tend to depress bond prices, though, because newer bonds featuring higher interest rates will be favored over older bonds with lower rates, thus causing their value to fall.
At times when the economy is sputtering, the Fed may move to lower interest rates to give the economy a boost, helping stocks while pushing the prices of existing bonds lower. Still, there are no guarantees; sometimes, bonds, too, will gain or lose value along with stocks.
Thus, while a 60-40 portfolio split can be perfect at some times, it won't be perfect for all -- and it's not really possible to know ahead of time what the stock market or bond market will do. In the current environment, with interest rates very low and starting to rise, bonds are still not offering much income.