Part III: Do bonds still diversify your portfolio?
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 has caused the bond decline.
The second article looked at some of the reasons that stocks could be down.
In this article, we’ll see that bonds still provide diversification to your portfolio, even though stock and bond returns are just uncorrelated.
Here is a simple example illustrating how diversification works, and why it’s valuable. Suppose we have several uncorrelated securities with return patterns like this:
- In 50% of the years, they return 20
- In the other 50% of years, they lose 10
- Knowing the return of one security in any year tells us nothing about the return of any other security in that year. They are uncorrelated.
On average, over time, each security returns 5 per year (if they return 20 the first year and -10 the second, the total return for two years is 10, or 5 per year). Each security is very risky, though – you could experience several bad years in a row. Knowing the return of one security in any year tells us nothing about the return of any other security in that year – they are uncorrelated.
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 get extreme total outcomes, 20 and -10, in only a quarter of the time. We get the expected return, 5, right on the nose in half the number of years.
If we increase our diversification, buying 8 of the securities, things get even better from a risk perspective without affecting expected return. The proportion of years when we get extreme results gets even smaller. The probability of a return of -10 is very small, about .4%. We’d expect to lose 10 about once every 250 years, versus every other year if we held just one security.
That doesn’t mean there is no risk – there are still losses. Losses are much less likely, however, occurring only about 15% of the time, rather than 50% of the time if we hold one security.
In general, as the number of securities grows, the risk goes down:
- The chance of losing diminishes
- The average loss if we do lose is smaller
- The standard deviation – a summary measure of risk, also declines
Similar analysis applies to holding bonds in addition to stocks. Of course, some of the assumptions we made about the “ideal” securities above don’t apply fully in the case of stocks and bonds:
- Expected returns for bonds are lower than expected returns for stocks. Therefore, the expected return of a portfolio incorporating both will be higher than expected bond returns and lower 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 impact on the range of outcomes than the example suggests. The risk reduction will be larger for larger bond proportions in the overall portfolio.
- Finally, even if the correlation of stocks and bonds were somewhat positive, the analysis would be more complicated but there would still be a diversification benefit.
In summary, 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 uncorrelated (or even only weakly correlated) is enough.
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