Thursday, February 01, 2007

the role of bonds in an investment portfolio a simplification of modern portfolio theory

A key tenant of modern portfolio theory is that a diversified portfolio of non-correlated asset classes when regularly rebalanced has long term performance that is superior to the compounded returns of any individual asset class in the portfolio.

This means that a mixture of stocks and bonds can beat the long term compounded performance of stocks or bonds individually. Portfolios with even more asset classes perform even better.

How does this work? Rebalancing. At the end of a year, if one asset class performs very well - perhaps exceeding your target allocation percentage by 20%, you sell some of it and buy more of your other asset classes until your target allocation has been met. You have effectively sold one asset class at a high price and bought the under-represented classes at low prices. How do you make money? Sell high and buy low! Rebalancing does just that.

In simple portfolio allocations, bonds are the asset class that usually, but not always, is outstripped by equities performance. Historically, we have been told to subtract our age from 120 to determine the % of bonds our portfolio should have. With young people often having little bonds - after all, at that age, who wants 5-7% average returns?

Unfortunately, the young investor and those that make recommendations to them confuse average returns with cumulative returns. They are simply not the same.

I recommend investors think of bonds as a form of stored investment capability - like a battery. When the market goes down, you have your bonds - often stable in value - as a source of capital to buy into a cheap market.

Bonds and the entire concept of non-correlated asset classes takes advantage of volatility. When markets push one asset class down, another asset class retains enough purchasing power to buy the depressed asset class at a discount. It's the equivalent of buying food or clothing on sale. Think value investing. However, most of the investment media and many brokerages make recommendations based on average annual performance - they ignore or fail to clearly discuss volatility. The result is that average returns are used to project growth -- the benefit from rebalancing is lost. Furthermore, cumulative investment returns fail to match average annual returns - it's a bar that cannot be met. If a fund drops 10% in one year and 20% the next, it's cumulative value will not equal 100% - it will equal 108%. Rebalancing helps bring the return back to 110%.

Without bonds or other non-correlating asset classes, there would have been no reserve money to buy more when the stock was cheap.

Perhaps the formula to determine the percentage of bonds should not be 120-your age, but rather, what is the expected volatility of your non-correlated investments - is there enough of your non-correlated investment (e.g.) bonds, to rebalance the rest of your portfolio if? If stocks drop 25%, will you have enough allocated in bonds to cover the 25% loss in stock?

Incidentally, the average rebalancing benefit is usually 0.5%. In a low expense mutual fund it could make a very big difference.

I'm sure there are modelling tools available to recommend the ideal % of bonds compared to the volatility of the rest of the portfolio.

My gut says that it should be at least 20% but possibly higher. What is your bond allocation?

Regards, makingourway


StealthBucks said...

I would like to throw an alternative thought in. In the days of Jimmy Carter long U.S treasuries paid about 18% and you could get a 30 year bond. Today long bonds are paying around 4.3%ish. That's an improvement of around 14%, thus creating the greatest bull bond market since the inception of our nation.

So here's my question. Do you think long bonds will go from 4.3% ish to -10%? If you do, by all means go long and overweight bonds. If you don't I'd really keep the powder dry and buy 6 month CD's or just stay in money market.

I know the god of bonds, Bill Gross, sees a slight rally in long bonds for the later part of 2006 but he's been singing that tune for some time now. (He might just be biased managing the biggest fund/bond fund on the planet)

I have no long term bonds but considerable cash. I call this tactical allocation. Finally, If I am wrong stuff it at me and copy this response and make me eat it. Blog opinions are not worth much.

Good job and good luck for 2007.

Anonymous said...

OK, a really stupid question: I keep reading about bonds as part of one's portfolio - but I don't even know how to buy them!

So far our portfolio is 100% stocks and mutual funds. I'm in the software industry and have a 'feeling' for tech stocks: we've beaten the Dow and Nasdaq every year for the past 5 years. But 40 is just a couple of years away, and I know I should do something to reduce volatility.

Can you recommend a site or book which would give good advice? Also (maybe fodder for another column) do you have any thoughts about index funds? The more specific the better!


P. S. Sorry if this has been submitted multiple times - the comment window for your blog is not cooperative. For example, the picture for the word verification comes up half the time as a broken link.

mOOm said...

A diversified portfolio won't neccessarily have a higher return than the best returning asset in it, even with rebalancing. But it will have a higher return for a given volatility. Any level of return can be obtained then through leverage which I've blogged about recently.

Bonds had a return that almost matched stocks from 1981 to 2001 as interest rates declined due to capital gains on bonds. The return on bonds is not just the interest paid. Going forward though it is hard to see such gains as either interest rates will stay near present levels or rise. In the short-term though they might fall in a recession. Bonds are great in recessions!

My investment portfolio is pretty much 50/50 stocks and bonds in the last year and a half. In retrospect that was a mistake. My trading results in my total stock exposure moving from much bigger than that to negative from day to day.

makingourway said...

First, I'd like to thank you all for the wonderful comments.
Ann, I've just posted, today, a new post that further discusses bonds.
Moom, thank you very much for correction / clarification regarding rate of return for specific levels of volatility. However, I do believe that any one asset class over a long period of time (30 years) will eventually mean revert, whereas the diversified portfolio will steam ahead.
Stealth, very interesting historic point. Raises a question as to whether bond investments should be oriented toward long term or short term / ultra short term products as well. Although there's some risk, the short term products do become safer than the long term ones.
Bernstein and Ferri seem to diverge on the topic. Bernstein prefers short term bonds or bond funds as appropriate, whereas Ferri is more experimental. My own oppinion is closer to Bernstein's.

Regards, makingourway

Anonymous said...

I am 52. 34% bonds.

I believe you mean the percentage of stocks in your portfolio here:

"Historically, we have been told to subtract our age from 120 to determine the % of bonds our portfolio should have."

Otherwise, a 20 year old should be entirely in bonds.

A similar rule of thumb is that your percentage of bonds should be your age.

One caveat is that rebalancing by selling has significant tax consequences for assets that aren't in tax sheltered vehicles such as IRAs or 401Ks.

Instead of selling leading asset classes, I put new savings into lagging asset classes.

I use my available shelters for bonds, not stocks.