Monday, February 18, 2008

Portfolio Risk Reduced With Combination Of Bonds And Stocks

A combination of stocks and bonds in ones investment portfolio can reduce the overall risk or volatility of investment results. It should be noted though that the bond component of the portfolio will reduce the overall return of ones investments in the long run. On the other hand the bond allocation has been shown to reduce the magnitude of negative returns in down equity markets.

A recent article in the American Association of Individual Investors summarizes returns given various portfolio allocations. The article notes several lessons to be learned from the behavior of the portfolios over different market cycles.
Lesson One: Mixing bonds and stocks moderates portfolio risk.
High-grade bonds and stocks are fundamentally different assets. Bad years for bonds are sometimes good years for stocks and vice versa. During this time period, bonds lost money in three of those years, and in those same years stocks earned money. Conversely, stocks lost money in four of those years, and at the same time, bonds earned money. It is also important to note, though, that 1987 and 1994 were below-average years for both asset classes—that serves as a reminder that both asset classes can have poor years at the same time.

Lesson Two: Portfolio risk rises disproportionately slowly as stocks are added to the portfolio.
Over this time period, the risk (as measured by volatility) of a 25% stock portfolio was essentially the same as the risk of the all-bonds portfolio. The additional risk of a 50% stock portfolio compared to an all-bonds portfolio is one-fourth the additional risk of an all-stocks portfolio.

Lesson Three: An all-bonds portfolio is not the lowest-risk portfolio.
Even risk-averse investors should own some stocks. The maximum annual loss for a 25% stock portfolio was less than the maximum for the all-bonds portfolio. That's because, when interest rates rise, all bond prices move south.

Lesson Four: Portfolio returns rise disproportionately quickly as stocks are added to the portfolio.
Over this time period, the 25% stock portfolio earned about 40% of the additional return on the all-stocks portfolio compared to the all-bonds portfolio. The 50% stock portfolio earned about 75% of the additional return.

Lesson Five: An often-overlooked risk for the long-run investor is the risk of having a too-conservative portfolio.
By focusing too much on volatility of individual assets instead of the volatility of the entire portfolio, many people often maintain a too-small stock exposure for their long-run horizon. Remember that over this time period, the 25% stock portfolio had a volatility similar to the all-bonds portfolio, but its returns were appreciably higher. And for many investors, the risk-return trade-off favors an even higher exposure to stocks.
A summary of the portfolio returns is detailed in the below chart.

(click on table for larger image)

portfolio returns various asset allocations stocks bonds
Five Big Lessons From Recent Market History ($)
American Association of Individual Investors

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