Monday, May 5, 2014

UPDATE: Bonds as a Hedge

The market has been more volatile in 2014 than last year.  When markets get rocky, many investors look for fancy products to “hedge” their risk.  The reality though is that high-quality bonds are the cheapest and most effective hedge available.

Since the start of the year, the Barclays Aggregate Bond Index (blue line) has been relatively stable and has proved a nice diversifier to the Standard and Poor’s 500 Stock Index (green line).

Over a longer time period, for example the ten years from 2004 through 2013, both stocks and bonds performed well.  Equities (blue line) and fixed income (orange line) returned 7.4% and 6.1%, respectively, compounded annually.  However, as the chart below demonstrates, when stocks did well, bonds tended to lag and vice versa.  And in this example from Morningstar, systematic rebalancing caused a portfolio of half stocks and half bonds (gray line) to actually outperform either individual asset class with less volatility.

Because interest rates are so low, some investors think bonds are a lousy investment.  But while bonds may have limited long-term return potential, they are still a terrific hedge against market volatility.

Fidelity Investments studied a rising interest rate environment from 1941 to 1981 and found that by adding 20% bonds to an all-equity portfolio, volatility dropped by over 20% (standard deviation went from 14% to 11%), while returns fell by less than 10% (annualized total return went from 11% to 10%).

In other words, even when bonds seem like a poor investment on a standalone basis, they can be a smart holding in a portfolio context.  For this reason, it pays to be disciplined about rebalancing.

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