Last week’s analysis of US bond markets since 1948 leads us to conclude that US Government Bonds should not form part of any global portfolio in an unconstrained world. Advisors may ask: should we avoid bonds as an ingredient in a diversified portfolio for the next week, next 30 years or forever?
Once again thanks to Paul Gambles of MBMG in Asia for providing this research piece by Craig L Israelsen on the topic.
During the 34-year period of rising interest rates between 1948 and 1981, an all-bond portfolio returned an average 3.83% per year, whereas during the last 31 years it produced an average annualized return of 8.82%. The difference in return for an all-bond portfolio during these two distinct time frames was a staggering 499 basis points per annum.
How about a two-asset portfolio? Let’s assume the classic “balanced” design, with 60% allocated to stocks (as measured by the S&P 500) and 40% to bonds, in a portfolio that is rebalanced annually. The differential in performance in a two-asset portfolio across the two time periods is much less dramatic, even though the positive impact of bonds is clear in the more recent 31-year period. A performance difference of 499 basis points in an all-bond portfolio shrinks to a 204 basis points difference in a 60% stock / 40% bond, two-asset portfolio (10.56% versus 8.52%).
A four-asset portfolio that allocated 40% to large U.S. stocks, 20% to small U.S. stocks, 30% to bonds and 10% to cash (with annual rebalancing) generated an annualized return of 9.52% during the 34-year period when interest rates were rising and a 9.99% annualized return during the last 31 years, when rates were falling. The performance differential across the two time frames now shrinks to a mere 47 basis points.
Clearly, as diversification increases within a portfolio, the impact of the performance of one asset class on the overall portfolio is significantly reduced (assuming the allocations are not skewed heavily toward only one asset). This is precisely why portfolios should be diversified – by doing so, we lower risk by preventing the bad performance of one particular asset class from sinking a portfolio’s overall returns.
For a person who places all of their investments in one asset – whether bonds or stocks or real estate – timing is everything. As it pertains to bond performance, the difference between the worst case 10-year period and best-case 10-year period for a 100% U.S. bond portfolio was nearly 1,300 basis points.
As we have stated on a previous occasions, “diversification is ‘the one free lunch’. Market timing between asset classes, even cash and bonds, can have significant effects.”The Rise and Fall of US Bonds - Part 2