Don't let fear of rising rates cause diversification mistakes

Interest rates may be changing sooner rather than later, but it still makes sense to keep bonds in your portfolio. Investors commonly look to bonds to meet key financial goals. It is important to focus on building a portfolio that will be resilient to a number of different potential future markets. Investors need to focus on what they can control. They need to examine why they are investing, their investment horizon, along with potential cash flow and liquidity needs they may have. Once they have established their goals, then they need to focus on the risks that they are really willing to accept to meet them. How have they reacted to previous market volatility and will future volatility impede them from reaching their investment goals? After evaluating your goals and risk tolerance you will find that bonds should play a role in a truly diversified portfolio. The primary reason to invest in bonds is for diversification. Going back over the past 88 years, stocks were negative in 24 calendar years and bonds were only negative in two years. Bonds act as a true diversifier to a stock portfolio. Bonds can be commonly called "negatively correlated" to stocks, meaning that they move in a different direction than stocks. This is not always the case historically, stock and bonds prices have both dropped together, but many times they will move in different directions. Because bonds were only negative in two years over the past 88 years, they have helped smooth returns and added a cushion to your portfolio when stocks declined. Another reason for bonds to be kept in your portfolio is for capital preservation. High quality intermediate-term bonds have been significantly less volatile than stocks. This fact makes bonds a good anchor for your portfolio. Diversifying across different types of bonds can further assist in managing risk against factors such as inflation, rising interest rates and defaults, all of which can hurt bond prices. The third primary reason for bonds is income. Regular interest payments have historically provided a stream of steady income. However, in a low-yield environment, investors have to make sure that they are not assuming a greater level of risk in search for higher income. Looking at the virtues of bonds, they can be less variable in terms of price, they can move in a different direction that stocks, and they can provide a steady stream of income; generally you find that bonds will be able to cushion your portfolio in a down market at the expense of generally underperforming in a rising stock market. How do you decide how much of your investment portfolio should be in bonds? You need to go back to your investment goals, time horizon and how much risk you can or are willing to assume. Your allocation to bonds hinges on all of these three items. Only after you have established a clear understanding of your time horizon, goals and tolerance for risk you can make the determination of the percentage of your assets that you should have in bonds. Most investors err with too much or too little when they make these determinations by themselves. This is a great conversation to have with your financial advisor or a trusted advisor. ----- Sharon L. Thornton is senior director of investments for Karpus Investment Management, an independent, registered investment advisor that manages assets for individuals, corporations and trustees. Offices are located at 183 Sully's Trail, Pittsford, N.Y. 14534; phone (585) 586-4680. Published: Mon, Aug 17, 2015