How bonds can help trim risk in an overheated stock market

Bonds investor looking at stock market charts — (Image credit: Sean Anthony Eddy/Getty Images)

Stock markets are still setting record highs, despite the unstable geopolitical backdrop and economic uncertainty. Market euphoria has been boosted by SpaceX's initial public offering (IPO) last week, and by the potential IPOs of OpenAI, the owner of ChatGPT and its rival Anthropic.

Yet market breadth is at record lows. Just a handful of AI-related names have been responsible for virtually all of the MSCI World's performance this year. What's more, in the past, bumper IPOs have sometimes been the sign of a market top.

In the current environment, some investors may want to take some profits, reduce exposure to stocks and remove the temptation to trade, while still remaining invested. Adding some bonds to your portfolio could be part of the answer.

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The return of bonds with the 60/40 portfolio

The traditional 60/40 portfolio (60% stocks and 40% bonds) fell out of favour between 2020 and 2024 after a series of unfortunate events. Throughout the pandemic, central banks held rates at, or below, zero, and bonds reached fresh highs. Yet from 2022 to 2024, inflation – which most investors had forgotten existed – returned with a vengeance. As interest rates spiked, bonds collapsed. As a result, a 60/40 portfolio of US equities and bonds returned 17.3% in 2022, its worst performance since 1937, according to Morgan Stanley.

Yet we are in a very different environment now. Yields on high-grade corporate and government debt are sitting at some of the highest levels since 2007, so investors don't sacrifice so much return in buying them (unlike 2020 and 2021). Higher starting yields mean that there is less risk of a sudden rise in rates sparking a 2022-style collapse. So a frothier stock market may make a 60/40 or 80/20 asset allocation look sensible again. The future is impossible to predict. However, a 60/40 approach has historically tended to offer good protection against volatility. A 60/40 US portfolio achieved a compounded annual growth rate of 7.3% over 200 years to 2024, according to Morgan Stanley. Stocks and bonds experienced negative returns in the same year on only 16 occasions, illustrating just how unusual 2022 really was.

Having a mix of bonds and stocks rather than all stocks has meant lower long-term returns. A global 60/40 portfolio would have returned 4% per year between 1901 and 2022 and an 80/20 portfolio would have returned 5%, but an all-stock portfolio would have returned around 6%, according to a report for the CFA Institute. Note also that the risk-adjusted return (the return relative to the volatility) was similar for both the 60/40 and 80/20 portfolios. However, a much more conservative portfolio of 30% stocks and 70% bonds had worse risk-adjusted returns. In other words, once you get beyond a certain point, being more cautious keeps reducing returns, but yields a more marginal reduction in risk.

All this implies that long-term investors should gauge bond exposure carefully and not be too conservative. Overdoing it will probably lead to lower returns. But it can still make sense temporarily to increase exposure in volatile markets.

How to adjust your bond exposure

One easy way to adjust your bond weight is to use a fund series such as Vanguard LifeStrategy, where you can move between the 100% Equity and 60% Equity or 80% Equity funds in a simple transaction. These funds are rebalanced daily and are very cost-competitive, with ongoing charges of 0.2%. Other choices include the Fidelity Multi Asset Allocator and the HSBC Global Strategy series of funds.

Alternatively, consider using a selection of index funds or exchange-traded funds (ETFs), such as iShares MSCI ACWI ETF (LSE: SSAC) for global stocks and Vanguard Global Aggregate Bond GBP Hedged (LSE: VAGS). This lets you adjust the stock and bond weight to your own preference.

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Rupert is the former deputy digital editor of MoneyWeek. He's an active investor and has always been fascinated by the world of business and investing. His style has been heavily influenced by US investors Warren Buffett and Philip Carret. He is always looking for high-quality growth opportunities trading at a reasonable price, preferring cash generative businesses with strong balance sheets over blue-sky growth stocks.

Rupert has written for many UK and international publications including the Motley Fool, Gurufocus and ValueWalk, aimed at a range of readers; from the first timers to experienced high-net-worth individuals. Rupert has also founded and managed several businesses, including the New York-based hedge fund newsletter, Hidden Value Stocks. He has written over 20 ebooks and appeared as an expert commentator on the BBC World Service.