Should investors have less of their money in bonds than usual because of low interest rates? 

    GUS SAUTER: A long term, strategic asset allocation is determined by a number of factors, including expected returns of various asset classes, the risk associated with those returns and the investor’s tolerance for risk.

    These factors are represented by two concepts in Modern Portfolio Theory (MPT). The first two factors are expressed by the Efficient Frontier theory and the third factor, risk tolerance, is explained by an investor’s utility curves. These concepts are mathematically combined in theory to determine a precise percentage of a portfolio that should be allocated to each asset class, such as stocks and bonds.

    If you expect lower returns from an asset class than it has provided historically, such as lower returns from bonds, then the math, and probably logic, would tell you to lighten up on bonds. To be clear, the solution is not to eliminate bonds from your portfolio because they will still provide the very important diversifying benefit of cushioning your portfolio if the market should pull back.

    However, an important consideration is that if you expect a lower-return environment for bonds, shouldn’t you expect a lower return for other risky assets, like stocks.  If that is the case, then the math of financial theory tells you that you should not change your asset allocation. In fact, stay the course with your long-term asset allocation is the mathematical solution.

    So it’s important to maintain a bond exposure at least somewhat in line with your long-term strategic allocation because of the diversification benefits that help offset a bear market in stocks.


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