New investors: do you need bonds in your investment portfolio?

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The traditional investment portfolio would have a component of bonds and stocks. Do you really need bonds in your investment portfolio? Canadian Couch Potato’s model portfolio of exchange-traded funds (ETFs) using iShares ETFs provides some insight. First, investors need to know at least at a high level what bonds and stocks are.

A quick primer on bonds

Essentially, when you buy bonds, you are lending someone money and getting interest income in return. Thus, bond prices are sensitive to changes in the benchmark interest rate. Common bonds include government bonds and corporate bonds. Long-term bonds generally have a higher interest rate. However, shorter term bonds make more sense even if they have lower yields now if you expect interest rates to rise in the near term.

What are stocks?

Stocks are stocks. So if you own stock, you own a percentage of a company. In other words, when you buy stock, you are buying part of a company. If a company earns profits persistently, it can pay dividends to its shareholders or reinvest the money back into the business for growth. The share price of a publicly traded company that increases its profitability will increase over time.

The Canadian Couch Potato Model ETF Portfolio

The Couch Potato Canadian Model ETF Portfolio uses iShares Core Canadian Universe Bond Index ETF (TSX:XBB) as a bond component and iShares Core Equity ETF Portfolio (TSX:XEQT) as equity component.

XBB has net assets of approximately $4.6 billion. As explained on its website, XBB is “designed to be a long-term core holding” that provides “broad, low-cost exposure to the Canadian investment-grade bond market.” The return of XBB is approximately 2.5% paid as a monthly cash distribution. Its management expense ratio (MER) is indeed very cheap at 0.10%.

With an ETF, XEQT provides convenient exposure to four ETFs that immediately diversify your investment portfolio among stocks in the United States (approximately 46% of the fund), Canada (25%), Japan (5%), in the UK (3%), and other parts of the world. The ETF’s MER is also reasonably cheap at 0.20%.

Overviews of the model ETF portfolio

At one end of the spectrum, the portfolio put 80% in XBB and 20% in XEQT. At the other end of the spectrum, it is the opposite with 20% in XBB and 80% in XEQT. The general conclusion is as follows. The higher the percentage of XBB held, the lower the volatility of the model ETF portfolio. Conversely, the higher the percentage of XEQT held, the higher the volatility. However, a higher percentage of XEQT also resulted in higher yields.

Over the long term, even a 1% difference in total returns can have a significant impact on your retirement. If you invest $500 per month over 30 years for a 9% rate of return compounded annually, you will get $817,845.23. For a 10% return instead, you would end up with $986,964.14. That’s a difference of $169,118.91!

In summary, XBB is a good consideration for bond exposure if you are looking to reduce volatility in your equity portfolio. In addition to reducing the overall risk of your stock and bond portfolio, you also earn a decent monthly cash distribution from the bond ETF. For some reason, XEQT is much less popular with net assets of only around $921 million. Investors may prefer stock ETFs in specific sectors or even picking individual stocks.

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