If you’ve watched the stock market recently and noticed how much it has been going up in the past two years, then you may be looking to abandon the bonds in your portfolio. Is that a good idea?

Since 2008, the stock market has been on an upward tear. It seems easy to forget that it took a beating of historical proportions before it began this run, and the Dow Jones Industrial Average still has not hit the high-water mark of over 14,000 that it reached in the fourth quarter of 2007. What is more easily forgotten for investors is where their risk tolerance stands. When stocks go up for an extended period, everyone wants to be in the stock game; little consideration is given to what happens when the market falls. The market is bound to correct at some point; it’s just the nature of the beast.

The simple solution is to position your portfolio so that you can handle the ups and downs without needing to make any adjustments. The worst enemy of investors tends to be themselves. Many investors are inclined to buy stocks high when recent stock market performance has been positive. They tend to sell low because that is when they are most fearful, usually after the market has been pummeled. This reactionary changing of investment philosophy kills investors’ returns over the long run.

While stocks have had a run-up of almost 100 percent from their lows in 2009, it would appear that they are “safer” than when the market was in free fall. The positive track record over recent history makes investors overconfident. The simple truth is that stocks aren’t any safer; they still have the potential to lose value. The risks are essentially the same every day. The solution is to build a portfolio that you can live with that serves your long-term needs but won’t give you a stroke when you open your statement after a market decline.

Putting together a portfolio that will serve you well is a matter of trade-offs. It is an age-old paradigm. Risk versus return. The more risk you take, the higher your potential profits but the higher the chances of losing your investment. Stocks have greater return potential than most other types of investments but carry a high risk. Safer assets (like bonds) generally do not have the return potential of risky ones (like stocks) but are less likely to experience major losses. Your investment strategy needs to be tailored to your risk tolerance. Risk tolerance is somewhat of a function of your time horizon. The longer you have before you need to liquidate all or part of your investment, the more interim volatility you should be able to handle. You have more time to recover, of course. However, the psychology of opening your statement and being stunned by a lower value than you expected can lead to reallocating your portfolio as a reaction. These portfolio changes may make you more comfortable today but hurt your long-term returns, no matter how long your time horizon might be.

Emotional decision making can be detrimental when it comes to investments. It is important to be honest with yourself. If your risk tolerance is such that you can’t handle the market troughs, you should consider having less of a percentage of your portfolio in stocks. You will do better over the long haul in a conservative portfolio, one that has a high allocation to bonds versus stocks and other fixed income investments. If you hold a more conservative portfolio through stock market highs and lows, then your returns will likely be better than if you buy stocks when the market is up and has had an extended rally (and you feel most confident in them) and sell when stocks are down out of fear.

In order to insulate yourself from downside risk you will have to sacrifice some upside. This is because the types of assets that will help you when the stock market falters are lower risk and do not have the appreciation potential. Bonds are the most prominent example of investments that can mitigate some risk in a portfolio—specifically, high-quality corporate or Treasury bonds. While they can be somewhat of a drag on performance when stocks are skyrocketing, they are surely appreciated when stocks hit the skids.

The important concept to understand here is that, by protecting a portfolio and taking less risk, there will be times of not getting the same return as the stock market. You have to be truthful with yourself. If you will be shocked by a 20 percent drop in the value of your investments, then you shouldn’t be in 100 percent stocks. If stocks go up 15 percent in a given year and you have a portfolio that is 50 percent bonds, then you are taking significantly less risk than a portfolio of stocks alone and you will likely get a somewhat lower return than whatever the market gets. Be realistic with your risk tolerance and don’t be greedy.

Sometimes, if you mess with the bull, you get the horns.

		Andrew J. Calogerakis, CFA is the portfolio manager at PensionTrend Investment Advisers, LLC where he co-manages the $250 million PensionTrend Common Investment Funds. He holds the Chartered Financial Analyst designation.