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.