Why Are Stocks And Bonds Both Down? Part III

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Part III: Do Bonds Still Diversify Your Portfolio?

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This is the third in a series of three articles on recent stock and bond returns.

The first article discussed how both bonds and stocks have declined together so far in 2022 and what is the reason for the decline in bonds.

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The second article looked at some of the reasons for the decline in stocks.

In this article, we’ll look at how bonds still provide diversification to your portfolio, even though stock and bond returns are reasonable. Andcorrelated.

Here’s a simple example describing how diversification works, and why it’s valuable. Suppose we have a number of uncorrelated securities with a return pattern like this:

  • In 50% of the years, they will be 20. let’s return
  • In the other 50% of years, they are 10. lose out
  • Knowing the return of one security in any given year does not tell us anything about the return of any other security in that year. They are unrelated.

On average, over time, each security returns 5 per year (if they return 20 the first year and -10 the second year, the total return for the two years is 10, or 5 per year). Every security is very risky, though – you could experience several bad years in a row. Knowing the return of one security in any given year tells us nothing about the return of any other security in that year – they are unrelated.

Now, let’s see if diversification helps. Let’s buy 2 of these securities. The expected return is the same at 5, but now we only get a very high total result, 20 and -10, about a quarter of the time. We get the expected return, 5, on the nose in exactly half a year.

If we increase our diversification, then by buying 8 securities, things get even better from a risk perspective without impacting the expected returns. The proportion of years becomes even smaller when we achieve peak results. The probability of a return of -10 is very low, around .4%. If we held just one security, we would expect to lose 10% once every 250 years, once every other year.

That doesn’t mean there’s no risk – there are still pitfalls. However, the probability of loss is very low, but only 15% of the time instead of 50% of the time if we hold a security.

In general, as the number of securities increases, the risk decreases:

  • less likely to lose
  • If we lose then the average loss is smaller
  • standard deviation – a summary measure of risk, also decreases

A similar analysis applies to holding bonds in addition to stocks. Of course, some of the assumptions we made about “ideal” securities above don’t fully apply to stocks and bonds:

  • The expected return for bonds is less than the expected return for stocks. Therefore, the expected return of a portfolio incorporating both would be higher than expected bond returns and less than expected stock returns.
  • Bonds are less risky than stocks – the range of returns is narrower. Adding bonds to a stock portfolio will have a more pronounced effect on the range of results than the example suggests. The risk reduction will be larger for larger bond ratios in the overall portfolio.
  • In the end, even if the correlation of stocks and bonds were somewhat positive, the analysis would be more complex but would still have a diversification advantage.

In short, adding bonds to a stock portfolio will reduce the risk of the overall portfolio, even though bonds don’t always go up when stocks go down. The fact that bond and stock returns are unrelated (or only weakly correlated) is substantial.

All written material is provided for informational purposes only. The opinions expressed here are solely those of Sensible Financial & Management, LLC, unless specifically quoted otherwise. The material presented is believed to be from reliable sources, but no representation is made by our firm as to the informational accuracy or completeness of other parties.

The information provided is not investment advice, a recommendation regarding the purchase or sale of a security or the implementation of a strategy or set of strategies. There is no guarantee that any statement, opinion or forecast made herein will prove to be accurate. Past performance may not be an indication of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index will incur fees and expenses that will reduce returns. Securities investing involves risk, including the potential for loss of principal. There is no assurance that any investment plan or strategy will be successful.

Credit: www.forbes.com /

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