Bonds for Diversification

While diversification is a popular topic within most discussions about investing, and is almost universally praised in investment circles, in order to ensure that one is diversified properly, it becomes important to understand what diversification achieves and the extent of diversification that may be required in a given situation.

If an investor held a single position only, they would be subject to the full brunt of the risk of that investment. While we may initially think that this would be a very bad thing, the degree of the potential problem is going to first depend on what the strategy is regarding holding it.

If we were just looking to capture a shorter term movement, in other words, to simply trade the investment, holding it while it moved in our direction and selling it should things not work out as expected, we may still want diversification to offset this risk, but the particular risk involved here may not be that significant.

We might want to spread this around by being involved in several trades at the same time, and especially in trades that aren’t that correlated, which may mitigate our overall risk somewhat, but at the price of potentially watering down our overall potential gain. If the first trade held the most promise, if we add trades with less promise, they may end up delivering poorer results and our return can become diluted.

On the other end of the spectrum, if our plan is to hold investments long term with no real regard to their performance or no exit strategy other than when we end up needing the money at some point in the future, this will in itself expose us to the full risk of the investment.

Since this strategy does not seek to manage risk at all, as opposed to the first example which looks to manage risk very tightly, where we’re looking to exit at the first sign of the trade not seeming to work out, we will want or at least should want to manage the unlimited risk of these long term trades somehow.

Diversifying Stock Portfolios With Bonds

Many investors choose to mix different asset classes to seek to accomplish this, most often mixing a component comprised of bonds with their stock holdings, where losses in one class of investments can often be expected to be offset by a better performance of the other asset class.

Stocks and bonds are driven by different conditions generally, with stocks being driven primarily by changes in the amount of funds in the stock market. What it really comes down to as far as the stock market in general is concerned is the demand for stocks, where if there is more demand overall, the stock market will go up, and when demand is reduced, the market declines.

There are a number of factors that influence how much money is in the stock market at any given time, but this in itself usually drives stock prices more than any particulars involving the company that you may own stock in or are considering purchasing, save for dramatic changes in a company’s business outlook.

If one were looking to diversify their holdings within the stock market, they would simply diversify the stocks themselves, and this is a popular strategy in fact. If they want to diversify market risk though, the risk that the demand for stocks will decline significantly, they need to look outside the stock market for this diversification.

Bonds, on the other hand, are driven somewhat by demand but even more so by fundamentals, in this case interest rates. Stocks do have a certain intrinsic value, what a company may be expected to yield in dividends, but this yield is speculative and it plays a lesser role in the overall expected returns of stocks.

Yield is the primary driver of bonds though because this is the fundamental reason people buy bonds, to benefit from the interest that they pay over time. As interest rates change, bonds become more or less valuable, just from the interest rate changes alone.

The Correlation Between Stocks and Bonds

Generally speaking, when the economy is strong, stock prices will benefit, because people have more money to invest in them and they will choose to put more money in the stock market. This growth tends to be inflationary though, which is good for stocks but bad for bonds.

Conversely, in periods of lesser economic growth, this isn’t good for stocks and bonds tend to outperform stocks during these periods. When both stocks and bonds become devalued, the extent of the decline of stocks usually is larger than the decline in bonds, so bonds can indeed provide a good hedge, to at least limit the risk of stock investments somewhat.

The same could be said of keeping a certain percentage of your portfolio in cash, reducing the risk exposure of your portfolio by simply not exposing as much of it, but bonds do have the benefit of producing at least decent positive returns in the long run, and do pretty well in terms such as 5 to 10 years as well.

It is common to recommend a certain allocation of stocks and bonds depending on one’s risk tolerance, which generally means how many years that you are planning on investing. Those with the longest time horizons are perceived as not really needing this diversification that much, where in one’s golden years, with a much lesser time horizon are seen to require more diversification.

Part of the reason for that at least is that as the time horizon shrinks, the risk of having to sell at a loss increases in turn. For instance, given the volatility of the stock market, if one chose to invest in it with only a 5 year time horizon, and then planned on selling, the risk of selling at a loss would be significantly greater than if one bought bonds and held them over this period, due to the greater volatility of stocks.

While stocks have delivered fairly reliable positive returns over the very long term, whether or not they will do so over a period of as short as a few years is much less certain generally. Depending on the market outlook, this can be a fairly reliable approach, if we expect a bull market to continue, but bull markets can end abruptly, as we saw pretty dramatically in 2007 for example.

Having money in bonds can deflect some of this risk, where if your stock component took a hit and your bonds remained stable, you would only take half of the hit if you only had half of your portfolio in stocks and the other half in bonds.

The price that is paid here is the same is in our example where we add further trades of lesser potential,  where we are willing to dilute our potential returns to benefit from reducing our overall risk.

Since bonds tend to deliver lesser returns over time, this is what happens with bond diversification, although it’s a price that can be well worth it to add stability and risk management to portfolios which may be exposed to a lot of risk due to our investment strategies.

How Much Diversification Do We Need?

Investors generally will seek out a certain amount of diversification of some sort, although often times they will just look to diversify their stock holdings and therefore may be left unprotected against market risk.

Market risk is the biggest threat though, so if one is just looking to hold stock positions for long periods of time, without any real exit strategy, it is usually wise to look to diversify to look to manage market risk exposure.

It is often assumed that simply holding your stock positions through bear markets and just waiting for them to turn around is sufficient, but bear markets can last a long time, and you may not have this much time. This is why longer time horizons manage this better, to at least afford the opportunity to wait out bear markets.

Even if you can wait it out, and even if things do turn around while you are doing so, this does not mean that exposing your portfolio to so much market risk is a good idea, or that it may have worked out.

If one is diversified more, for example having only half of their investments exposed to stock market risk with the rest in bonds, the overall value of one’s portfolio will decline less, and it may also turn out that the bonds end up performing well throughout this period, leading to a faster recovery from the market downturn.

Many investors wonder how much of this diversification is needed at certain points in their life, and for whatever reason, the recommendations for diversification that are given tend to be on the light side.

There are two components here, with one being how much diversification one needs for a given strategy, the simple buy and hold strategy for instance, as well as how choosing different strategies may affect the need for more or less diversification.

Diversification is all about managing risk, and that’s really the only reason we would want this, as it does come at a certain price, and that price is the deviation from what would be the ideal course to maximize our expected returns.

There are other ways to effectively manage risk though, and the better we manage risk, the less we need diversification to help with this. For instance, a plan to be in a market during more favorable conditions along with a plan to reduce one’s exposure when things are not so favorable, limiting one’s drawdown during these times, can also manage risk, and often manage it much better than simply diversifying by asset class.

In any case, since bonds do tend to perform quite well over time, perhaps not as well as stocks do, but with less risk overall, they are the better choice as far as risk management goes, especially versus a buy and hold stock strategy. While we may want both asset classes, we want to pay attention to having enough diversification.

The investment industry tends to favor stocks over bonds though, and more than anything, this is what guides recommendations to limit the amount of diversification through allocating enough of one’s portfolio toward bond investments.

One ultimately chooses how much of this diversification one wishes, but it’s important to realize that bonds can be a wise investment in themselves, and certainly can be used to reduce one’s market risk to a more comfortable level, especially if one’s time horizon is not long term.

We should be looking to match the time horizon required for a certain strategy with the time horizon that we have, and when we do that, it turns out that bonds should play much more of a role in the portfolios of many investors, especially as we move to the latter third of our lives.