By Thomas Pechin
Client Service Advisor
Over a long time-horizon, we assume the equity market will outperform the bond market. The example in the graph below shows that the S&P 500 Index is up over 282% since 1/1/2004 while the Aggregate Bond Index is up just over 91%. Given this assumption, why would anyone invest in bonds and not just put his or her whole portfolio in the S&P 500?
For some younger, aggressive investors that have time to make up for losses, a portfolio of 100% equities might make sense, but for most it is not an ideal allocation. Bonds provide diversification, income, inflation protection and preservation of capital to a portfolio. A 60/40 portfolio is made up of 60% equities and 40% fixed income. It is designed to utilize the strengths of bonds mentioned above and reduce volatility in order to achieve a steady rate of return.
Diversification reduces portfolio risk because funds in different investment vehicles react differently to certain events and this has the potential of lowering portfolio volatility. The S&P 500 Index and the US Aggregate Bond Index have low correlation coefficients (changing from positive to negative, depending on the relevant period). A correlation coefficient refers to a number between -1 and +1 and states how strong a correlation is. If the number is close to +1, then there is a positive correlation. Both indices move in the same way. If the number is close to -1, then there is a negative correlation. Each index moves in the opposite way. If the number is close to 0, then the variables are uncorrelated (there is no pattern). Often, historically, the correlation coefficient between the S&P 500 Index and the US Aggregate Bond Index during market downturns has been negative and sometimes close to -1, which indicates that, during these periods, either there is little correlation among both indices (which is better than a positive correlation) or there is a substantial negative correlation among both indices (the opposite direction correlation being ideal to offset some of the downturn of the equities). An example of this would be how bonds tend to outperform equities in tumultuous times (some more so than others). However, not all bonds are the same (just as not all equities are the same): corporate high yielding bonds have a higher positive correlation coefficient to equities, so they may not perform as well in a recession as less risky bonds. Therefore, it is critical to distinguish among types or equities and bonds to properly identify correlations.
There have been multiple large drops in the stock market in the past 90 years. The most famous example being the crash of October 1929. If you had invested all your retirement funds in the stock market at that time, you would have lost over 86% of the value of your investments. We may not see anything that serious in our lifetime, but odds are we will see multiple pullbacks of some degree. Less drastic examples would be the S&P dropping 28% in the first half of 1962, largely due to the Cold War, dropping 36% during the Vietnam war (specifically November 1968 to May 1970), dropping 27% from November 1980 to August 1982 after the decade of inflation that was the 1970’s, dropping 33.5% from August 1987 to December 1987 and dropping 56.4% during the Great Recession from December 2007 to June 2009.
It is possible those invested in only equities will make up those large losses at some point and earn more than those invested in a diversified portfolio over time. This is assuming investors are willing to not change their strategy through the greatest periods of market uncertainty and are fine with seeing a large loss in their account, even if it may only be temporary. Most investors dislike losses more than they like gains and do not want to invest in unfavorable or underperforming portfolios for a few months, let alone a few years, so for the vast majority a portfolio invested 100% in equities is unrealistic. Another major issue arises if investors need to withdraw funds during market pullbacks to cover their expenses. This leads to selling at low equity valuation points, which locks-in what otherwise would merely be unrealized low valuations of unsold equity positions.
Over the 12-month period starting in September of 2018, we have seen the strength of the 60/40 portfolio in action. During this period, the S&P 500 Index was up a modest 2.13%, while the US Aggregate Bond Index was up 10.06%. This has been fueled by investors becoming less optimistic due to the slowing of global growth, geopolitical tensions and trade wars. Because of this, equities have seen little appreciation, but the increased demand for safer investments has decreased the yield on interest rates and boosted the price on outstanding bonds.
During that same period, the US Aggregate Bond Index outperformed the MSCI ACWI ETF, which captures equities in 23 developed and 26 emerging markets and was down by over 0.5%, by an even greater margin.
To highlight the decreased volatility a 60/40 portfolio offers, we have chosen some of the biggest market moving days of August 2019 and compared AOR (a 60/40 allocation fund) and SPY (S&P 500 Index fund).
The graph below shows a comparison between the 60/40 fund, the S&P 500 and the Aggregate Bond Index during such one-year period. Note the lower drawdowns of the 60/40 fund, compared to the S&P 500 in December 2018 and late May/early June 2019.
At the end of the day, the most important thing for investors is to meet their goals. Whether it’s saving for retirement, paying for their children’s education or buying the cars of their dreams. A portfolio made up of only equities has the potential to offer a higher return, but having a less volatile portfolio with a steady rate of return often is the best way to ensure you meet those goals.
S&P 500 Index – Is an index that measures the performance of 500 large companies listed on stock exchanges in the US. Arguably the greatest measure of the US Stock Market.
Aggregate Bond Index – The most common bond index. The Aggregate Bond Index consists of nearly 17,000 bonds. The index has a large range of bonds from investment grade debt to treasuries. This excludes municipal debt and junk bonds, however.
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