Excessive risk is equated with excessive returns. But not everyone has an interest in high-risk, high-return portfolios. For investors who want to manage risk in their portfolio, are bonds the answer? A financial advisor will likely say yes, but why? Let’s dig into the details.
The Role of Bonds in Risk Management
Bonds have often served as a counterbalance to equities. If we view volatility as risk, we can say that stocks have more volatility than bonds and thus more risk. Bonds help offset equity volatility by traditionally remaining reasonably stable. In this way, they provide some stability in an otherwise volatile portfolio. By adding bonds to a portfolio, an investor also replaces riskier assets (i.e., stocks) with less risky assets.
Of course, bonds have less volatility (i.e., risk) and also lower returns than equities. But that is the price for stability and risk management.
To say that bonds are negatively correlated to equities means that as equities rise, bonds fall and vice versa. This is the counterbalancing effect mentioned in the previous section. However, correlations aren’t all or nothing. There are degrees of correlation.
Correlation is measured from -1 to +1. A positive correlation means the prices of two assets typically move in the same direction. The closer to +1, the more in sync price movements tend to be. A zero correlation means there is no correlation between two assets. A negative correlation means that the prices of two assets generally move in opposite directions.
A negative correlation means that different factors drive the prices of two assets. These factors consist of macroeconomic conditions and economic and policy drivers.
This brings us to the question — what is the degree of negative correlation between bonds and equities? A study by PGIM shows that the correlation between stocks and bonds has been mostly negative over the last 70 years. The correlation has rotated around zero correlation, periodically flipping from negative to positive. The following shows various periods of correlation:
- 1950-1965: -0.16
- 1965-2000: +0.28
- 2000-2020: -0.29
A common configuration for managing portfolio volatility while pursuing returns is the 60/40 portfolio. It has been around for a long time and remains popular.
The Traditional 60/40 Portfolio
In a 60/40 portfolio, 60% of assets are allocated to equities, while 40% are allocated to mostly government bonds. Most will claim this configuration works well and provides a reduction in risk. But does it? This goes back to identifying the correlation regime we are in.
From the PGIM study, we can see how well the 60/40 portfolio has performed, depending on which correlation regime we’re in.
- Positive correlation of 0.3: returns = 8.0%, volatility=8.2%
- Negative correlation of -0.3: returns = 8.0%, volatility=6.9%
It’s not a surprise that the negative correlation regime has lower volatility for a 60/40 portfolio. PGIM took their findings a step further and configured a 42/58 portfolio. That means 42% allocated to stocks and 58% to bonds during a positive correlation regime. The results were:
- Returns = 7.1%, volatility=6.9%
Returns are lower due to less allocation to equities, but volatility is also lower than the 60/40 portfolio during the same regime.
With quantitative data backing up the conclusion, we can say that bonds help manage the overall risk of an investment portfolio.
Does that also work for an investment portfolio of mainly rental properties? If we go back to our definition of risk, we say it is volatility. Can bonds manage that risk further?
Treasury bonds are considered one of the safest investments available. They are low return and low risk. If someone with a real estate portfolio begins adding more bonds, they reduce their real estate holdings, assuming the portfolio contains only bonds and real estate. That does help manage overall risk in the portfolio because less risky assets are replacing riskier assets. Of course, it’s best to talk any portfolio configuration over with your financial advisor.
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Diversification does not guarantee a profit or protect against a loss in a declining market. It is a method used to help manage investment risk. Past performance is no guarantee of future results. The investment return and principal value of an investment will fluctuate so that, when redeemed, may be worth more or less than their original cost.