Why hold bonds for retirement?

Q – The stock market seems to go up 20% in many years, so why would anyone have bond funds in their retirement portfolio when saving for retirement if they yield 4% or less?

A – Bonds can play a crucial role in retirement savings due to four characteristics; (1) Bond prices are much less volatile and don’t move in sync with stocks thus smoothing out volatility of the total portfolio, (2) While 4% is the yield, the returns can be much higher if interest rates drop, thus sometimes bonds have an annual return higher than stocks, and (3) different types and quality of bonds can be purchased to diversify your bond allocation increasing the bond allocation return, (4) By sometimes moving in an opposite direction than stocks, when the portfolio is rebalanced, the higher asset (usually stocks) is sold to buy the lower asset, bonds or cash. While lowering the return somewhat, volatility drops, and the returns can be more than adequate for retirement. The balancing act is not to use too high a percentage of bonds, which lowers returns and affects the portfolio's growth.

Later in retirement, bonds can provide income without reducing the principal. If you only need 2% or 3% from your retirement savings plus Social Security to live on, then a high-quality 4% bond fund looks pretty good. Additionally, I’ll note that stocks will experience many years with negative returns, which is less common with bond investments.