Why Bonds? #4 – Attractive Investment Diversification (video)

– Posted in: Asset Allocation

Remember that asset allocation is your most important decisions. Bonds provide attractive investment diversification is the fourth of four short videos that address why CDs, Bonds, and Bond Funds are critical to building an all-weather portfolio—even during low interest rates.

Video Transcript: Bonds Provide Attractive Investment Diversification

Coming up: Bond returns are uncorrelated with stock returns. What does that mean? And, why is it important?

So, Why Bother With Bonds? Our fourth reason is that Bonds can be an attractive diversifier in your portfolio. Not only do bonds dilute the amount of the portfolio at risk in the stock market, but the portfolio is strengthened by bonds which are poorly correlated.

Learn about Correlation and understand Investment Diversification

This has a magical benefit for you, but first let’s understand the concept. Correlation is a measure of whether stocks and bond prices move together, or independently from each other.

Ideally, we would find two investments that had attractive average returns, but where one had a good year exactly when the other had a bad one. On a scale of -1 to +1, these would be very negative, but unfortunately these only exist in our dreams.

Uncorrelated, or poorly correlated, means they are independent from each other. This is terrific.

Things that move in the same direction at the same time are positively correlated.

Now before we get to the magic I’ve promised, we need to introduce one more thing: we need a way to describe the volatility of these returns.

The average annual return is the expected value. It’s useful and valuable, but it doesn’t indicate volatility. So we use this measure called standard deviation to describe the distribution of returns. It simply means that the total return will be within one standard deviation in either direction, roughly 7 out of every 10 years—or in this case within the range from -10% to +30%. Further, it means that the total return will be within two standard deviations for 95 out of every 100 years. Now let’s put it all together.

To illustrate two perfectly correlated funds let’s combine the S&P500 fund from one company with the S&P500 fund from another. Presumably they are perfectly correlated and the combination is a weighted average.

Here’s the part that may blow your mind: a portfolio of assets that are not perfectly correlated always provides a better risk-return opportunity than the individual assets on their own.

For example, here we combine an equal amount of two funds with the same expected return and the same volatility that are completely uncorrelated, meaning the movements are completely independent and unaffected by each other. The standard deviation becomes less than the weighted average. The combination is better than the individual funds on their own. Wow, where do you find an uncorrelated fund like that? The short answer is: bonds. The longer answer includes a warning that the correlation of two assets depends on the time period they are compared.

Let’s look at some actual returns.
• These three years stocks returns went down but bond returns went up.
• These four years stocks went up and bonds went up too.
• And for these years, corporate bonds moved in the same direction as stocks, but treasury bonds moved opposite.

The most useful correlation information comes from comparing asset classes over a long period of time. An important point I want you to take away is that U.S. Treasury bond returns have almost no correlation with stock returns adding valuable stability to an investment portfolio. Being uncorrelated (or, near zero) means their values move independently from each other—but that doesn’t preclude that sometimes they move in the same direction.

Now it’s time for some fun. I’ll give you two facts. You choose the fact that is true. Here’s one: High-yield bonds are less correlated with the stock market than US Treasury bonds. Here’s the other: Choosing stocks and bonds that are uncorrelated give investors a “free lunch”.

That’s ok, because I only made a brief comment on this. Junk bonds, or bonds issued by companies with poor credit ratings, are euphemistically called “high yield” bonds and are sold to investors chasing after the highest yield for their bond holdings. These are more positively correlated with the stock market, and often perform poorly at the very time you need their stability.

This is true. The overall net result is to get more return for the same amount of volatility, or risk. That’s the free lunch. While moving in opposite directions at the same time would be ideal; being uncorrelated, or even poorly correlated, is very good. This is why high quality bonds are an attractive diversifier

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Footnotes And Video Production Credits for Attractive Investment Diversification

This video may be freely shared under the terms of this Creative Commons License BY-NC-SA 3.0.

Video copyright 2009-2014 Rick Van Ness. Some rights reserved.

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  • Tom March 11, 2014, 10:37 pm

    This information is so important. You have a wonderful website here. It’s helping me very much and I thank you for that.

    • Rick Van Ness March 11, 2014, 11:03 pm

      Thanks for leaving this note Tom. I’ve been working hard on another series about Bond Basics, which I hope to finally post tomorrow. 🙂 —Rick

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