‘Bonds? We don’t need no stinking bonds’.
*(With apologies to Mexican bandit, Alfonso ‘Gold Hat’ Bedoya).
Stock market declines make for sexy headlines. Bonds, however, are boring. Sometimes boring is good.
Two key investment themes are asset allocation and diversification. Asset allocation is the mix of asset classes in your portfolio. Good investment portfolio design combines (ideally, non-correlated) asset classes, like stocks and bonds, for example, to provide bond zig when stocks zag.
Diversification with bonds helps to offset a stock market decline. Overall portfolio volatility is more moderate therefor and there are more potential sources for returns. With the buffering effect of bonds, the investor experiences smoother portfolio performance. And this consistency is more acceptable to the average investor.
Investors sometimes say, however, ‘but bonds don’t pay anything’. True. Bond yields have recently touched 40-year lows as governments pursue low interest rate policies. (A small bond yield is better than a negative stock return … but never mind).
As important as yield is the role bonds play as stabilizer that makes them such a valuable contributor to a portfolio. Witness the market volatility since November. Stock markets everywhere are down from their October peaks … but bonds are up.
When markets correct, investors run from stocks to the relative safety of bonds. Demand for bonds bids prices up and bingo – capital gain. (Plus, the usual bond income payments). During 2000, 2001 and 2002 when stock markets globally were down -10%, -11% and -20%, Canada Government bonds returned over 10%, 8% and 8%. Again, stocks down. Bonds up.
Some say that asset allocation doesn’t work. It does work. It’s just been proven to work yet again. Asset allocation and diversification are THE antidotes to a down stock market while at the same time maximizing potential sources for returns. And bonds are one of the best ways to diversify.
Some investors (and Advisors) may claim to be immune to stock market corrections. But few are. It’s during a stock market correction that the ‘volatility doesn’t bother me’ argument doesn’t make the cut. Those who thought they were immune may find themselves making knee-jerk reaction decisions at the exact wrong time.
If down market volatility bothers you and you feel you must ‘do something’ then review your asset allocation as documented in your investment policy statement. If it still reflects your long-term objectives, tolerances and parameters, then there is no need to change policy or asset mix as a result of stock market volatility. But do consider rebalancing with additional opportunities for diversification like US, Euro, Asian and Emerging market bonds.
Create wealth with stocks. Preserve it with bonds.
Originally published in the Business Thompson Okanagan news, March 2008.
Doug Cronk CFA is Manager, Investments for a Canadian Pension Fund.