I continue to see articles, talk shows and Tweets touting the “110″ rule for investing, saying that the percentage of stock you should hold in your portfolio should equal your 110 minus your age and the remainder should be in bonds.  Likewise, I also see a lot of simple “age in bonds” advice, even from the likes of John Bogle in Forbes recommending that you hold your age in bonds on a percentage basis.

So, if you’re 70 years old, you’d be holding somewhere between 70-80% of your holdings in bonds according to these recommendations.  Historically, bonds have been viewed as the safest of the safe, and to some degree, they will always be the only true “risk-free” asset since we live in a world of fiat currency and the US government can always just print more money so they will never default on their bonds (although the value of the dollar may become worthless in that scenario).  What many people are missing is that there’s a growing bubble in US Treasury bonds right now and people may be setting themselves up for massive losses in their retirement portfolios when they thing they’re being conservative.  Here’s how:

How Bond Investing Works: Inverse Yield and Price

A bond pays a coupon, but the value of the bond itself fluctuates as well depending on market conditions, inflation expectations and other factors.  When bond prices decline, the yields rise and when the prices rise, yields decline.  So, ideally, you want to buy a bond when the yield is high, lock in that rate and then have appreciation in price over time such that the yield to newer investors is lower, but you’ve derived income on that higher yield all along and then lock in a gain on the underlying price.  Similar to a stock, you want to buy low and sell high.

How Bonds Can Decline (and the have before)

Today’s situation is dramatically different.  Yields on government bonds across all maturities are at lows not seen since the 1950s (which by the way, returns following that period trailed equities and actually lost to deflation for the next 30 years).  Therefore, unless we enter an unprecedented period of extreme deflation, we’re highly unlikely to see gains in real terms in bonds in the next several years.  So, investors in bonds, bond funds, bond ETFs and other such vehicles may very well take a substantial loss on their holdings that they otherwise considered to be very safe.  By buying now, you may very well be “buying at the top” and then be surprised when your account shows major losses when investors flee bonds for gold, stocks or whatever other instrument becomes more attractive.

Why Investing Rules of Thumb are Dangerous

This age in bonds formulate may be entirely suitable for one seventy year old and completely unsuitable for another.  Even assuming they have the same life expectancy, no near term investment horizon issues and they are both risk-averse, in retirement, people end up in vastly different financial situations in everything ranging to current financial obligations like mortgages and debt to income options like pensions and social security.

• Retiree #1 - This retiree started collecting Social Security early and didn’t have a sizable income during their career.  As such, the Social Security payments are $500 monthly.  There is no pension or other income aside from Social Security so they are living completely from their savings (which in this case is comprised of 70% bonds, remainder stock).

• Retiree #2 – This retiree didn’t start collecting Social Security until age 65 and also had a sizable income, so monthly payments are $2000.  Additionally, there are pension payments coming in at $3000 per month.  Finally, as an astute real estate investor, they’re receiving $2000 monthly free and clear from a rental property.  Therefore, total income excluding savings is $7000.  Same portfolio composition as Retiree #1.

As you can see, even though both retirees are the same age, because of their financial situation leading up to retirement, even with the same size nest egg and life expectancy, they have vastly different needs in terms of risk tolerance and bond allocation.  If bonds were to take a 30% haircut, Retiree #2 would be virtually unaffected because changes are they’re not even drawing from their portfolio at all.  However, Retiree #1 is heavily dependent upon income from their portfolio for monthly expenses.  This could be devastating.

So, this isn’t to say that bonds don’t still have room to run.  They very well may.  And if we face a severe deflation cycle, bonds yielding anything are attractive since fiat currency declines in value.  However, just be warned that while you may be recieving a 2% or 3% yield on your investment, you could very well lose 15% on the underlying bond price within a year.