Successful investing isn’t just about “the math”.
Equities have the best long-term returns and tax treatment. There are some strong arguments that an all-equity portfolio will outperform. However, that approach hinges upon having a solid plan with extra wiggle room and executing it all with perfect discipline. If you can do that – great! Maybe you have trained as an investor since childhood. Personally, I think that is easier said than done for most of us.
Successfully executing an investment plan is also about controlling our behavior.
We all have a lurking inner emotional Hulk Investor that will smash our portfolios if we let it take over. The average investor behavioral drag on investment returns is 0-2%/yr depending on portfolio risk level. That is the population as a whole – individuals who fully give in to the emotional beast can do much worse.
There are some good investor behavioral strategies to avoid this. Choosing a good financial advisor to help you plan and to talk you down from impulsive behavior can help. That comes at the cost of fees. If going that route, you will want to understand what you are getting for your money to ensure that you are getting good value.
We can also design our portfolios to avoid poking Hulk Investor in the eye as much by adding some bonds.
Using bonds in your portfolio can help to soothe the beast.
That can come at the cost of some return. Just like with advisor fees, you should understand how this works to make sure that you are getting the best value for it. Today, we will examine how bonds can help dampen Hulk-Investor-provoking volatility. We’ll compare how they perform in that regard to some other asset classes.
The basic understanding we develop today will also give us the foundation to pick the right kinds of bonds to best fulfill their intended role in our portfolio. We’ll expand on that next week. Assessing our risk tolerance to help choose the optimal percentage allocation of bonds for our portfolios will follow that.
Our risk capacity, risk tolerance, and impulse control all determine how close beneath the surface our Hulk Investor resides.
That beast’s sensitivity to provocation changes with time. It is provoked by the greed or fear that is largely triggered by price volatility (large rapid up or down movements in value). Many people think of volatility only as price drops and the financial media perpetuates that. There is some truth to it in that the natural movement of markets over time has been up and therefore a move in the opposite direction means a price swing.
However, upward volatility can be equally damaging to our returns if our greedy Hulk Investor gets its way. People using credit cards to buy Bitcoin when it was sky-rocketing is a good example. Leverage (using credit to invest) increases risk. It magnifies losses as well as gains – plus the emotions generated by them. Only use leverage deliberately and judiciously. Not emotionally. Fear can also be a powerful emotion when we are winning, causing us to sell out early due to fear of loss. The recent volatility of weed stocks is another good example where the big green guy may make an appearance.
How do bonds soothe our inner Hulk Investor?
Adding bonds to a portfolio can help soothe the beast by decreasing portfolio volatility. This is through a couple of mechanisms.
One is that bonds are not strongly correlated with equities in the long run.
If stock and bond prices both went in the same direction, then a portfolio holding both would fluctuate wildly in value. If they move in different directions, it smooths those oscillations. Kind of like adding waves together in physics class. It turns that Hulk is creating gamma radiation into something less stimulating.
Using some income-producing lower volatility holdings also helps decrease the overall price swings of the portfolio on the ride up.
Mixing some bonds in with stocks fits the bill nicely.
Bonds are poorly correlated to equities. Is it true?
The Recent Past Has Been Awesome
Over the past twenty years, bond price has been inversely correlated to equity market price. This means, when equities go down, bonds go up and vice versa. That is a powerful relationship for someone investing in both asset classes and rebalancing periodically. That combination means that you sell whichever one is high in price to buy the other one while it is on sale at a discount. It mechanically makes you “buy low and sell high”.
The chart below shows this relationship. The U.S. ten year treasury yield (how much interest is paid) is tightly mathematically related to its price. When bond yield goes up, bond price drops. So, a positive correlation in the chart below between bond yield and stock prices means that bond prices move in the opposite direction from stock prices. The double negatives of that explanation will make most people’s heads spin. For simplicity, I have made it that green is good (inversely correlated price) and red is less favorable (price moves together).
The Bigger Picture – Less Awesome, But Still Good
History stretching back beyond the past twenty years shows that the advantageous inverse correlation between stocks and bond prices over the past 20 years has been a bit atypical. Often bond price and equity price have moved in the same direction over the past >100 years as shown below. That makes sense since interest rates usually rise while the economy is humming along. Those conditions are also favorable for equities.
A quick glance at all of the red in the chart above may suggest that bonds don’t hedge against equity drops over the long term. However, a closer look tells otherwise.
First, the periods of inverse correlation were periods where you would really need to be soothing the emotional beast to stop you from panic selling. Bad recessions, The Great Depression, and major market crashes. You could argue about that narrative – there are always doom and gloom predictions around (it sells). However, I bet that things were particularly scary at the points in time that I am mentioning. You won’t really know how you’ll react until you actually experience it. My Hulk Investor eyes would have been flashing green for sure. Bonds can help preserve wealth in those downturns compared to stocks.
Second, the average correlation coefficient over the >100 year period is very close to zero (-0.1) and rarely does it even touch +/-0.5 as it fluctuates. So, even though bond prices may not always be inversely correlated to stock prices, they are weakly or uncorrelated over the long-term. While not as effective for buying low and selling high with rebalancing, it is still effective at dampening the volatility of stock prices.
How does the correlation between the US stock market and bonds compare to other asset classes?
Holding a balance and diversified portfolio means having holdings from around the world and amongst different asset classes. That helps to smooth returns if these holdings are not strongly correlated to each other. The average correlation coefficient over the past decade for a variety of holdings compared to the S&P 500 US stock market is shown below.
As you can see from the table above:
- Equities from different parts of the world are still pretty strongly correlated to the US stock market. So are real estate investment trusts.
- A combination of the stock market forces and interest rates influences preferred share prices. Hence, it makes sense that they have a moderate correlation to equity markets.
- In terms of having an asset class that is not correlated to equities… bonds and gold are the winners.
So why not just use gold instead of bonds to soothe the beast?
Gold and stock price are not correlated. Plus, gold is shiny and heavy. Precious…. Sounds pretty good.
However, gold does not generate income. Bonds do. The value of gold, beyond that for making jewelry and some electronic components, is largely speculative. People will point to gold as a store of value. Central banks stopped using the “gold standard” as currency back-stop a long time ago. So, I think that it is speculative because the bulk of that value is simply dependent on what people feel it is. [Editor Note: My gold engagement ring was easily Loonie Doctor’s best investment ever :)]
The other reason is that gold is not as good for portfolio smoothing as bonds are is that the price is volatile. The lower volatility of bond prices is better to soothe the beast. Let’s look a bit more closely at volatility.
Bonds fluctuate less wildly in value than equity (are less volatile).
There a few ways to quantify that decreased volatility. I will attempt to distill complex statistical nerdiness to what matters for our discussion. Largely because it gives me flash-backs to courses that I tried to sleep through.
One is to use the beta calculation.
This calculation describes how big of a price swing occurs in one stock compared to a swing in the market as a whole. A stock or bond with a beta of 0.50 will fluctuate half as much in value than its comparator. If the beta is negative, it means that fluctuation is in the opposite direction.
Using beta for contrasting bonds to equities does have a weakness. Beta may not describe volatility as well when the two holdings that are not strongly correlated. Gold and bonds fall into this category when comparing them to equities as already shown.
The standard deviation of price can also be used.
Standard deviation describes how far price swings up and down relative to the average price over a time period. It is intrinsically valid that way. So, it does not run into the correlation issues that beta does. However, standard deviation also assumes a “normal distribution” of data points. Problematically, stock or bond prices can have skewed distributions.
Neither method is perfect. However, it is instructive to attach some numbers to what I am talking about regarding volatility:
As you can see from the table above:
- World equities are both strongly correlated and also have similar high volatility.
- Canadian preferred shares are moderately correlated and their volatility lies somewhere between equities and bonds.
- Bonds are the least volatile.
- Gold is as volatile as equities when looking at standard deviation.
But wait… TLT has way more volatility than the shorter-term government bonds.
Double actually. Similar to equities. Having longer-term maturity dates makes the price of these bonds fluctuate more when the prevailing interest rates change. We sure have seen a lot of that over the past decade. Bonds are not all equal in terms of correlation and volatility.
For me I have used investments in real estate to form a major component of my portfolio and that smoothes out the ups and downs of the market. Real real estate, and not real estate flavored stocks like reits, are illiquid and thus not subject to the daily volatility. Bonds have a smaller component in my portfolio to round it out and smooth it a bit more.
Hey Xrayvsn! I agree that “real” real estate is a way to diversify with something that moves differently from stocks and is also taxed favourably. Real estate prices can still be volatile and emotion provoking though. We saw a huge run up and probably near-term peak here recently. You folks in the US saw it move like that about a decade ago. The pace is different from equity or bond markets (months instead of minutes) as you say. However, the relative illiquidity, associated costs for maintaining or selling, and frequent use of leverage can stir the emotions nonetheless if you feel like you are missing out or are trapped. If you want to see the emotional green eyes flashing, just bring up real estate in Vancouver or the GTA here.
Real estate can be a great alternative investment if you take the time and effort to do it right. Since it is a very localized asset, having the time/effort/skill is vital. By the nature of being local, it is also subject to more “specific risk” unless you have a huge diverse real estate portfolio. Kind of like owning a few well picked stocks instead of an index ETF. Lots of people do it well, but I am personally going the lazy route with my investing and have all the real estate exposure that I want with my house. I also like the rebalancing aspect of a liquid bond ETF.
Thanks for starting and broadening the discussion!
I think real real estate is quite volatile, too, but because it’s not marked to market daily, we don’t see that volatility which is a nice behavioural advantage of it. As Warren Buffett like to say, no one stands at their fence line every morning shouting out the price they want for their property.
Hence the % allocated to different markets is almost irrelevant within equities:) over time what matters is that your portfolio is spread out and decided upon allocations stay the same. Stocks here and there tend behave in similar ways over the long stretch.
I love it when data suggests I can do less.
Yes, the important point about bonds (at least government bonds) is that although the correlation between stocks and bonds is often positive, during financial stress the correlation turns sharply negative, just when we need it to, which is what makes bonds excellent diversifiers of equity risk, smoothing the ride and providing capital from appreciated bonds to buy depreciated equities as we rebalance.
Another way to look at this is how often stocks and bonds go up at the same time and down at the same time. No one complains when they go up at the same time, but it’s not so nice when they go down together. Fortunately, as it turns out the latter is quite rare, having happened only 3 times, on an annual basis since 1928 – in 1931, 1941 and 1969. With bonds down a bit this year and stocks looking a bit dicey, who knows, maybe we’re in for one if this rare “both down” years this year?
Thanks Grant for the link. I am glad that I started adding some bonds and even though they have dropped slightly when equities drop at times, the fact that the magnitude of the drop is so much less is psychologically helpful to me. I like the thought that I’ll have proportionally more money to pick up some equity bargains when I rebalance. If people focus only on the return of bonds then they will miss the point of their function. That is important and applies to when picking bond types too which where I will focus next week.
I couldn’t agree more about the importance of understanding the purpose of the different components of your portfolio. I frequently hear people say that bonds are a poor “investment” because of poor returns, not understanding that bonds are not about return (we own equities for that), they are about smoothing the ride so we hang on to our equities and actually get the returns of equities that are there in the long term.
I use ZDB in my 60/40 portfolio. It is working well. I will only need it for its liquidity when the time comes to re-balance. Currently I can rebalance with incoming cash however.
I believe all investments can be risky. In particular equities. Thus it is better to build a moat around them to protect oneself.
I tend not to worry all that much about the ETFs themselves. I see it all as a process rather than the products. The products will change. I am certain of that.
I try to use investments to reach whatever goal I have. I tend to be investment asset agnostic. Every investment has its own pros and cons.
100% equity portfolio should only be held by the very very young. That is those who have a massive amount of human capital left.
Great points Dr. MB. You have a deliberate approach where you know the role of each part of your portfolio, what matters to you, and what doesn’t. That is what I am working towards also and I find myself simplifying it each step of the way.
Thanks for the detailed post, LD!
I have to go back and read your investment articles again. My current management firm may be selling. 😞
Hey BC Doc. I remember one of the firms I was with early on got bought out several times by progressively larger firms. The advisors stayed the same and I didn’t notice anything other than progressively nicer websites to figure out how to navigate. That said, it was a good time to stop and reflect on how things were going and value for dollars.
My firm (Mawer) has been doing well and the value has been good despite the higher fees vs. ETF. However, this was a surprise as they often touted their culture of independence. The ETF world is looking more attractive if they do sell. Even when you have a firm you like, it is unlikely to be the same for 15-20 years. Guess I have to look into ETFs again. Any site you would recommend?
Hi BC Doc. My honest response to your situation would be two-fold:
1) I wouldn’t make any hasty decisions if you are happy. You may find that nothing actually changes with the buy-out. Plus, if you have accrued large capital gains with funds that aren’t transferrable that adds a wrinkle. Especially if in a corp or personal taxable account which requires some tax planning. RRSP/TFSAs are easier to deal with.
2) Learning about ETF investing and adding that to what you do is a great idea regardless. Canadian Portfolio Manager and Canadian Couch Potato are probably where I would start.
I am also planning some posts on the dilemmas of #1 (Should I Stay or Should I Go) as part of building the process for #2 specific to professionals on my site. The basic framework is done. My recent posts about how corps work, flowing eligible dividends through a corp, and the role of bonds in a portfolio are all laying some of the knowledge-base groundwork. My goal is to have a process with embedded links to more details on the rationale behind it. Plus, hopefully (if I can pull it off) a value-added surprise – how’s that for a teaser 😉
looking forward to your future post!
I am not planning to make any quick changes. Like you pointed out, I do have significant capital gains and it’s hard to turn around a sailing ship. I looked into ETFs before and found that Mawer outperformed after fees. I will likely put my future contributions into ETF if there are significant management changes.
I don’t like to see negative numbers in the safe, fixed income portion of my portfolio. Interest accrued is not reflected in the price fluctuation of bond ETFs. For this reason, I have created a GIC ladder for the fixed income portion of my portfolio. Price never drops and actually goes up as interest is added. Psychologically this approach suits be better than seeing bond prices fluctuate. All fixed income is in RRSP, so I like to see this account go steadily up.
It is good that you know what agitates your psyche. The individual red price numbers are a common irritant for many people and the GIC ladder is a good approach to it. Fluctuations in price may bother me more psychologically closer to when I plan to start taking money out. I like the increased liquidity of bond ETFs at this stage. However, when about five years out, I will probably start building a GIC ladder too.
Thanks for this website. Lots of info to think about.
I have been mulling over the pros and cons of a GIC ladder in my RRSP. I have stuck with bond ETFs. My concerns with them is the liquidity and worry over changing interest rates, ie should I wait til the next fed announcement before selling some of my Bond ETFs to buy GIC. Also seems like you need to go for longer duration to get a decent yield. What do yo think of yield difference? Looks like you can earn better with GIC than bonds in addition to not seeing it fluctuate wildly.
Good question BC Shrink. I honestly don’t know that I can give a good straight answer!
The bond ETFs reflect their underlying assets which are pretty liquid. Especially government bonds. In fact, the advantage of bonds over GICs (in my mind) is the liquidity for rebalancing. GICs have the advantage of not being rate-sensitive and a slightly higher yield, but at the cost of tying up your money.
For me, it depends on my time horizon. If I were planning to not access my bonds money for a horizon longer than the duration, then interest rate changes shouldn’t matter to that plan. If I were close to accessing my money (that is when fluctuations matter most), I would lean more towards a GIC ladder with enough money coming up each year that I wouldn’t need to sell anything else. If a fantastic year, I might bleed some money from my overperformers with my rebalancing and keep the ladder going. If a bad year, I may use the GIC money. My personal thoughts are honestly a work in progress on that aspect.
In terms of yield. Yes, you get more yield for a longer duration. However, you are taking on more interest rate risk for that. It is a balance. My feeling is that the sweet spot is somewhere in the 5-10 year range. My main purpose for bonds is stabilization. So, I honestly don’t care much about minor differences in yield. My equities are where I take my risk and seek my larger returns. The risk/reward is better with equities – especially when you consider the after-tax reward.
This is all just my opinion. No one can really know where interest rates will go. I am also a believer that most probabilities etc are priced into the market and I can’t predict surprises one way or the other.