Have you ever wondered why most portfolios have a mix of stocks and bonds in their portfolio? Is there a reason why? The primary reason is because stocks and bonds, more or less, have a negative correlation. This means that if stocks are falling, there is a good chance that bonds are trading higher. This is important because the bigger position you have in bonds, the less painful your slide in stocks will be. Having a negative correlation is extremely important in an investors important. Since 2008, the SPDR S&P 500 ETF (SPY) and the iShares 20+ Year Treasury Bond ETF (TLT) has had a negative correlation of -43%. (Bull Oak Capital as of 8/2016)
However, you do not want too large of a position in bonds an too small of a position in stocks. If this is the case, you will likely miss large move to the upside. And missing large positive moves can be devastating to your long-term portfolio value and your financial goals. In fact, staying invested and participating in the stock market’s highest performing days is crucial. According to Putnam, if you were to have invested $10,000 in 2003 and you were to miss the market’s 10 best days over the next 15 years, you would’ve lost $20,460 in upside potential, or 4.89% in annual returns.
On days when the S&P 500 was down, Treasury bonds were more likely than not to help dampen those negative days. This is the whole point behind diversification. By not having all of your eggs in one basket, you reduce your risk by splitting your money between these two different asset classes.
What Are Stocks?
As a quick recap, owning a stock is to own an equity stake in a corporation. Even if you only own one share of a company, you are technically an owner of the firm, albeit to a small degree. This is why those who own stocks are called shareholders. By being a shareholder with one or more shares, you are able to participate in the profits of that firm. You are also subject to the losses of the firm as well. The inherent nature of equity ownership is risky. The stock market reflects this by showing vast amount of volatility. The efficient market theorem states that if you are taking on a specific amount of risk, you are hoping to be compensated for that level of risk. If the markets were perfectly efficient, then you will always receive that reward. Of course, this is not true, but this aspect of the rule holds a very important lesson: it is extremely rare to find an investment opportunity that offers a high reward with minimal risk. Active money managers are always attempting to find these investment opportunities, but I address here why this is often a fruitless endeavor. As such, we advocate passive investing. And as an equity owner, you should be prepared for a rocky ride.
What Are Bonds?
Unlike stocks, bonds are not as volatile. They offer a higher level of safety and they typically perform well when there is an economic slowdown. They are also limited to the upside and offer subpar returns over the long term. Like stocks, though, they can lose money and they are also subject to similar market risks. A bond is a debt instrument and they are higher up on the creditors list. This means that if the company/agency/etc. that issued the bond were to go through bankruptcy, secured bond holders have higher priority when the company sells off its remaining assets. Secured creditors are first in line to settle their debt, then unsecured creditors second, and so on. Most of the time, common stock shareholders are last in line (hence the higher level of risk they incur).
When a bond is issued, the bond owner is technically lending money to the issuer. Bonds have a maturity date (typically somewhere between 2 years and 30 years) and offer a fixed coupon rate. When the bond matures, the bond owner receives par value in return (typically $1000/bond).
How Stocks and Bonds Work Together
In a perfect world, you (an investor) would have an indefinite time horizon, capital to invest, and a high risk tolerance. If this were the case, then you would invest in nothing but stocks as they offer the greatest potential for capital appreciation. However, this is not a perfect world. Chances are, you are not going to live forever, you have capital spending needs (such as retirement), and you may not have a risky appetite for market risk. If this sounds more like you, then you are not alone. Those that take on too much equity risk often sell out when volatility spikes. Do you know of anybody that sold their stock portfolio in 2008 or 2009? Most people have and it might even be you. As such, you need to temper this equity risk by investing in bonds.
As stated before, bonds are often negatively correlated to stocks. And this is a good thing. If your stock portfolio declines during an economic slowdown (or an anticipated slowdown), your bond portfolio will most likely rise. (Note: There are instances when this did not happen, but I am assuming normal economic behavior for this illustration) This is because investors typically flee risky asset classes (e.g. stocks) for safety (e.g. bonds, specifically government bonds). The mix between stocks and bonds is a tricky one, but for those with a higher risk tolerance and a longer time horizon typically opt for more stocks and vice versa.
I suggest that you talk with a financial advisor before drafting your own investment portfolio to ensure that you have a proper asset allocation. If you would like a second opinion and/or help with your portfolio, we are more than happy to assist. Contact us here.