The following is a response to a question from a retirement investor in their 20's wondering if they should invest in bonds - and specifically municipal bonds - in order to have a diverse portfolio.
Bonds are there for when you need money. They lose to inflation. We hold bonds for withdrawal needs in the next 5-10 years, as well as to add stability to the portfolio.
If your time horizon is 20-30 years or greater, any money you invest in a bond today will be worth much less in the future. With a bond, we lend $1 today, and receive interest payments as well as our $1 back in the future. If we have inflation, you won’t be able to buy as much when you receive your investment back. While it is impossible to say how much less, but think 1/3-1/2 over 30 years, and less if we have higher inflation going forward.
I tend to invest in safe and boring bonds, because we aren’t compensated for taking on risk in bonds as we are in stocks. Today, safe bonds pay 1-2%, while inflation may be 3-5%. My retirees and others are losing money here, but they are gaining stability and certainty that they will be able to withdraw money without a loss. Could we invest in higher risk bonds? Sure, but you lose the safety and security – the main reason we own bonds in the first place.
Bonds are a tough market to think about holding a long-term investment like many used to after 2008 because the government showed they aren't above changing the rules of investment. With GM, the bond holders lost their claims on assets that was supposed to belong to them. So, you have higher risk in corporates. For that reason, I stay toward governments - domestic and foreign - but I'm also conflicted about that. Municipalities have massive financial issues coming up - pensions, etc. I wouldn't buy a long-term municipal bond; at least our federal government can print money to get out of financial issues, but that, of course, is where the inflation starts.
I'm not suggesting you or anyone else doesn't need bonds, but it's my job in part to try to match assets to time horizons. My starting portfolio is 30% bonds. For retirees it is usually more. But, for those with longer time horizons it is usually less, and much less when you have decades. I don't mind the ups and downs of the market, it comes back. Bond principal only declines against inflation.
Here is a pic of the growth of $1 overtime. When you have time, a healthy amount of small company stocks has led to the highest amount of wealth.