Oh when I was a kid, I got no respect. I played hide and seek. They wouldn’t even look for me.
– Rodney Dangerfield¹
For a number of years, I’ve been having conversations, particularly with financial advisors, about portfolio construction. The specific focus of interest is often what I (Vanguard) think about the inclusion of various asset (or sub-asset) classes in client portfolios. Whether it’s REITs, commodities, hedge funds, you name it, I’ve had discussions about it. The common thread is that they were all looking for diversification. My instant thought is, “What’s wrong with bonds?”
Like the late comedian Rodney Dangerfield, bonds suffer from a chronic lack of respect. It seems that everyone is “playing hide and seek,” searching for the “best” diversifiers to include in client portfolios, and they aren’t even looking for bonds.
In my discussions, I typically reserve judgment on the various investments being asked about and whether they are suitable. I generally fall back on our research, which relies on probabilities of success. Often I will show a chart, similar to the one below, that demonstrates various investments’ track records during turbulent periods for the equity markets. Specifically, if we sort monthly equity returns into deciles and examine the worst periods, we find that high-quality bonds² have proven to be one of the best diversifiers for a portfolio. That’s pretty impressive, especially compared with the other asset classes that I get asked about, none of which has provided downside protection when investors arguably needed it the most.
Despite years of repeating the message, I find that bonds still get no respect as one of the best diversifiers of equity risk. But who can blame advisors for wanting to include more appealing investments in client portfolios? After all, fear of the possibility of higher interest rates has prevailed for more than a decade.
The recent volatility in the equity markets left me curious: To what extent did the various diversifiers offset stock-price declines? The chart below presents the results for the six trading days between August 17 and August 24, when the U.S. equity market returned –11% and caused some investors to panic. It wasn’t surprising to me that, once again, bonds held up fairly well, mitigating some of the losses from the equity portion of balanced investor portfolios.
The message to me is as clear as it ever was. High-quality bonds remain effective diversifiers, especially during sharp equity market declines, and they deserve more respect.
I would like to thank Yan Zilbering for his contribution to this blog post.
1 Rodney Dangerfield: Jokes. Accessed September 9, 2015, at http://www.rodney.com.
2 A bond whose credit quality is considered to be among the highest by independent bond-rating agencies.
All investing is subject to risk, including the possible loss of the money you invest.
Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner, or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline.