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Why Are Stocks And Bonds Both Down? Part III

by
Rick Miller
Ph.D., CFP® - Founder

October 25, 2022

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.

All written content is provided for information purposes only. Opinions expressed herein are solely those of Sensible Financial and Management, LLC®, unless otherwise specifically cited. Material presented is believed to be from reliable sources, but no representations are made by our firm as to other parties’ informational accuracy or completeness.

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 statements, opinions or forecasts provided herein will prove to be correct. Past performance may not be indicative of future results. Indices are not available for direct investment. Any investor who attempts to mimic the performance of an index would incur fees and expenses which would 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.

This article originally appeared in Forbes.

More articles by Rick Miller Filed Under: Investments Tagged With: Investments, Stock Market, stocks and bonds

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This content reflects the opinions of Sensible Financial®. We may change it at any time without notice. We provide this content for informational purposes only. Although we endeavor to keep the information up-to-date and correct, we make no representations or warranties of any kind, express or implied, about the completeness, accuracy, reliability, suitability for a particular purpose or availability with respect to the website or the information, products, services, or related graphics contained on the website for any purpose. We do not intend the information contained in this website as investment advice and we do not recommend that you buy or sell any security. We do not guarantee that our statements, opinions or forecasts will prove to be correct. Past performance does not guarantee future results. You cannot invest directly in any index. If you attempt to mimic the performance of an index, you will incur fees and expenses which will reduce returns. All investing involves risk. You can lose any money you invest. There is no guarantee that any investment plan or strategy will succeed.

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