What purpose should bonds play in your portfolio? It depends on how much risk you’re willing to take on. Here’s what you need to know about volatility, variability, and variation.
© 2017 The Vanguard Group, Inc. All rights reserved.
Emily Farrell: Ulm from Washington asked us, “How does a bond fund act as a counterbalance to a stock fund?” I think that might be a great place to start, right?
Kevin DiCiurcio: Yeah, it’s a great place to start. This is the title of our webcast. I mean this is a major point that we want to make today is to talk about the role of the bonds in the multi-asset portfolio. And we brought a couple of charts with us today to help describe it. But before we look at those, I just want to level set something with the audience. I may, going forward, and I probably have already talked a lot about risk. And I know risk is very personal to people. Typically risk to them might be falling short of your investment goals.
When I refer to risk today, I’m really going to be talking about portfolio risk. And portfolio risk is all about trying to measure the uncertainty of your return outcomes. I might use terms such as volatility, variability, variation. These are really just kind of fancy terms that describe fluctuations in your return portfolio that describe that uncertainty. So I just kind of wanted to—
Emily Farrell: Well, Bryan and I will just call you when you use those fancy terms.
Kevin DiCiurcio: So with that, I really would like to move into the couple charts that we have today.
Emily Farrell: Absolutely.
Kevin DiCiurcio: So the first chart is our volatility chart.
Emily Farrell: And I think if you’re watching at home, that should be up on your screen right now.
Kevin DiCiurcio: Great. All right, so here is our volatility chart that we want to show you today. Another thing I should mention is that for an investor with a total return objective, total return is really you want to maximize your return for some unit of risk. So for total return objective investors that have a balanced stock bond portfolio, even if it’s a 60/40 portfolio, equity risk is the primary driver of the return variation in your portfolio. So 60/40, it still explains about 95% of your return variation. And in plain talk, that just means that your portfolio moves with the equity market. It’s very highly correlated with the equity market.
So we see the use of bonds, investment grade bonds—sovereigns, Treasuries, investment grade credit bonds—to serve as that instrument that you can use in your portfolio to really hone in on the level of uncertainty that you’re willing to take. Really balance your portfolio’s risk with one’s own risk tolerance. And that’s sort of the relationships that we have on this chart here.
So what this chart shows, going from left to right, is a series of stock/bond portfolios ranging from 100% equities, 100% stocks to 100% bonds. So bonds are being added into the portfolio as you go left to right.
On the vertical axis, what you’re seeing here is a measurement of your return volatility in that portfolio going back from 1920s I believe, ’20,’22through 2015. That’s the red bar. The gray bar is going to show you your average returns during that time period. So this chart really shows you kind of the crux of the tradeoffs that long-term investors face is that you add more bonds to your portfolio, you add more certainty or less uncertainty to your return expectations, but your return expectations also decline. So it’s really balancing these two. But because equity risk is the driver, we feel like the really critical decision is finding that stock/bond mix that gives you comfort so that you can tolerate equity market downturns.
I believe you talked about discipline early. You know, I think it might be obvious that adding bonds adds more stability. What’s less obvious is the investor behavior part of that. If you have that stability, you can weather the equity market downturns and, actually, rebalance your portfolio instead of panicking and selling. That would be a much more value-add activity to be rebalancing when equities decline in value.
Emily Farrell: Do you have similar conversations with your clients kind of walking through, whether this chart or not?
Bryan Lewis: Yeah, I was just going to mention that this comes up frequently too, as well, is when you see, especially after the election with equities going up, very strong returns, and then you start seeing rates go up, price go down on the bonds, it’s tempting to want to shift out of something that’s not performing very well and go after something that’s giving growth or at least has risen more rapidly.
And truth be told, by the time you start to figure out maybe what you want to do, you miss most of the upside anyway. So trying to time this, most investors, the average investor won’t be able to do that well; and professionals can’t do it well to begin with. So I think, to Kevin’s point earlier, about your asset allocation, that’s going to drive a lot of the risk and return over time. And avoiding the temptation to kind of market time or chase performance is something that I’ll partner with clients and reevaluate.
But it all comes back to that plan that I was alluding to earlier is if you maintain that discipline over time, again, you’re going to increase your chance in the long run that you could be a successful investor.
Emily Farrell: Absolutely. Yeah, and I think it really kind of speaks to just the role of bonds in the portfolio, right?
Kevin DiCiurcio: That’s right. We have a second great chart that I think might be a little bit more insightful. Viewers may not have seen something like this before. And we’re calling this the bonds as ballast slide. You may have heard colleagues at Vanguard Investment Strategy Group, other parts of Vanguard, talk about bonds being the ballast to your portfolio. Does that mean something different than what I just referred to about stabilizing your uncertainty of your return outcomes?
To me, ballast doesn’t mean something different, but what it is, is diversification in practice. The previous slide that we went through talks about volatility over very long periods of time, 1922 to 2015. It’s smooth. It’s an average experience. We know that assets in the real world, they have time varying relationships. So what’s really important to investors is to know that these bonds provide diversification when I need it most. And we talked about equity risk being the primary driver. You need your bonds to be the ballast when we have steep declines in the equity market. And that’s what the second slide is showing us here.
So if we look at this, what we have here is about 22 years of monthly return data, and we’re targeting the worst 25 monthly returns of the broad equity market during that 22-year period. Really, we call it the worst decile, worst bottom 10% of equity returns. You could see that’s plotted on the far left.
So on average, we’re plotting average levels here, average return levels. On average over the 25 worst performing equity periods, the equity market has lost about 7%. And the rest of the chart, what we’re showing is how those other asset categories and asset classes performed during those worst 25 months of equity returns.
What you can see is the only positive bars are investment grade either Treasury bonds or aggregate bond indices, muni bonds, indices as well, have provide positive average returns when equity markets suffer steep declines. To me, that’s what it means to be ballast. That’s when you need your diversification the most. You’ve got emerging market equities, REITS, it’s an equity sector, dividend stocks. These all have a lot of equity risk. they’re going to follow the equity market lower for the most part.
And the other thing, people like to reach for yield with high-yield bonds, emerging market bonds. The credit risk in these sorts of investments is such that it’s very highly correlated with equities as well. So it’s really the investment grade Treasury bonds, credit bonds that serve as this ballast.
Bryan Lewis: And you also have to look at this way as well is that when I talk to investors and my clients about, you know, looking at this very chart or kind of talking through this is when you look at the, for example, dividend paying stocks, they’re going to pay you the dividend, but they’re also going to be very volatile, right? 2008 is a perfect example of that. Even though they might be paying dividends, their principal or their capital return is still very negative in kind of a worse-case scenario. And that’s not what you want for bonds, right? You want the bonds to add that stability.
And typically when I look at portfolios of clients that try to reach for yield, you typically see they have large-cap value stocks, so their portfolio is tilted in that direction which presents a risk. They also lower the credit quality for reaching for yield. And then, you know, when I analyze the portfolio, and we have the conversations and talk through the underlying risk of the portfolio, it’s enlightening. And trying to figure out, you know, maintaining that diversification because things are not going to always move in the same direction.
Emily Farrell: Yeah. So I mean I think that it is really interesting because we did get a lot of questions, I think, specific about dividend-paying stocks and using that as a replacement with bonds. But I guess the kind of takeaway is maybe buyer beware?
Bryan Lewis: Exactly.
All investing is subject to risk, including the possible loss of the money you invest. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Diversification does not ensure a profit or protect against a loss.
Bond funds are subject to the risk that an issuer will fail to make payment on time, and the bond prices will decline because of rising interest rates or negative perceptions of an issue’s ability to make payments.
While U.S. Treasury or government agency securities provide substantial protection against credit risk, they do not protect investors against price changes due to changing interest rates.
This webcast is for educational purposes only. We recommend that you consult a tax or financial advisor about your individual situation.
Advice services are provided by Vanguard Advisers, Inc., a registered investment advisor.
© 2017 The Vanguard Group, Inc. All rights reserved.