How Bonds Can Keep You on Track for Retirement

(MoneyWatch)  About half of all financial assets in the world are invested in the bond market. But most individual investors have little understanding of bonds. Over the next month or so, I'm going to do a series of posts on bonds to help you understand how bonds can keep you on track for retirement.

The main reason you should consider owning bonds is because they generally serve as a good hedge against volatility in the stock market. For example, in 2008, when the S&P 500 lost 37 percent, the bond market (as measured by the Barclays Capital US Aggregate Bond Index) was actually up by about five percent.

Yet I'll bet most people couldn't tell you what the bond market's return was last year. That's part of the problem. Investors don't pay enough attention to bonds. They consider bonds boring. But boring can be a financial lifesaver.

If 2008 did a lot of damage to your retirement plans, it's probably because you didn't have enough high quality bonds in your portfolio. While past performance is of course no guarantee of future returns, 2008 was a pretty good example of how bonds can help protect your assets during a financial crisis.

Here's a quick rundown of the numbers: In a hypothetical portfolio that was about half bonds and half stocks in 2008, the account would have been down roughly 16 percent, which is a lot better than minus 37 percent.

Now the bond market can produce negative returns, but the negatives have generally been modest and short-lived. I'll talk about returns in a future post.

So why do bonds often behave so differently from stocks?

• Well, bonds are basically loans. When you buy a bond, you're essentially loaning your money to the issuer of the bond for a certain period of time. In exchange for loaning the money, you receive an annual interest payment and the issuer promises to give you your money back when the bond matures.
• That's a lot different than stocks. With stocks, you don't know what your return will be each year and there's no requirement to give you your money back at any time in the future. That's why stocks tend to be a lot more volatile than bonds.

Because stocks and bonds offer such different return characteristics, it's generally a good idea to balance your retirement portfolio with some money in riskier stocks and some in more stable bonds.

At the end of the day, you'll need to decide how much of your portfolio you'd like in bonds. As with every investment, there's always a trade off. Bonds are generally more conservative, which means you have to accept modest returns on part of your money. But, they generally offer a lot of stability, which gives you more control over the value of your retirement plan. As you get closer to retirement, that becomes a big deal.

Bottom line: Bonds serve as an important risk management tool for retirement accounts. If you have a healthy dose of high quality bonds, they can help preserve your portfolio and keep you on track for retirement.

Next week, I'll talk about how to figure out if the bonds you own are safe enough for your retirement money.

As with all financial matters, consult your individual advisor before making any financial decisions.