Diversification is widely regarded as the only ‘free lunch‘ for investors. By diversifying investments across different asset classes, investors can reduce their portfolio risk without sacrificing returns. The classical 60/40 portfolio (i.e. 60% equities and 40% bonds) plays a central role in dampening volatility. For example, bonds historically counterbalanced negative equity returns in ~50% of months due to the imperfect correlation between the assets (see Figure 1).
This imperfect correlation creates an expectation that bonds can “protect” a portfolio by offsetting a poor stock outcome in either (i) the short term or (ii) the long term. Does this expectation hold up when examining the data?
Correlation vs. Return protection
Diversification potential is traditionally measured by measuring the ‘correlation’ between two investments. A low correlation stabilizes the volatility of a portfolio. However, it offers no guarantee that investors are actually better off with a low correlation. To illustrate – a lottery ticket has no correlation with most investments but is of limited when protecting portfolio returns.
In practice, investors are more interested in (1) how an investment performs over the long term (after inflation). Furthermore, it is of importance (2) whether an investment offers protection in times of market volatility. Finally, (3) return protection should also be considered over longer timeframes. The following segments explain how equities and bonds relate to each other across these three dimensions.
- Long-term performance
A 2023 study sheds light on the long-term outcomes of various investments by analyzing returns since 1890 from developed countries worldwide. The researchers estimate the probability of investors losing capital in real terms (i.e. after inflation) across different investment horizons.
The results suggest that bonds’ reputation as a safe haven has been overestimated over the long term. In fact, over a 30-year period, bonds have a ~6x higher loss probability than globally diversified equities (27% vs. 4%; see Figure 2). The conclusion is that bonds as a stand-alone investment perform poorly over the long term and appear ‘riskier’ than equities – measured in terms of real value retention.
- Protection in the event of market volatility
While bonds, on their own, seem to have a limited ability to retain value, the asset class may offer protection in the event of sharp downturns in equity markets. However, in practice, bonds’ track record in this regard is inconsistent. Most of the dampening is primarily driven by the lower equity exposure in a portfolio rather than a direct upward movement of bonds themselves.
Examples where bonds had a ‘protective’ effect are March 2020 and October 1987. In both cases, the stock market fell more than 20% within one month, while bonds returned about 5-6%. With that, the return protection of the standard 60/40 portfolio was 2% (i.e., 40% * 5%). The question is whether this outweighs the negative long-term return impact. On the other hand, bonds achieved flat returns in October 2008 when equities again fell nearly 20%.
In short, the extent to which bonds can protect a portfolio from sharp stock market downturns cannot be considered reliable.
- Long-term protection
As mentioned, return protection should also be evaluated over the long term. For example, it is quite conceivable that in the rare cases where equities lose capital (after inflation) over a 30-year period (see Figure 2), bonds offer solace. Therefore, the researchers looked specifically at how the long-term performance of the asset classes developed conditional on each other’s returns.
The researchers calculated that if global equities lost value (4% probability), bonds only achieved a positive real return to compensate for this loss in 47% of these specific cases. In this way, bonds also offer unreliable return protection over the long term.
Bluemetric Insight | One of Bluemetric’s Investment Beliefs is that risk has multiple dimensions. The standard approach aimed at dampening volatility by means of low correlations has practical limitations. This approach does not consider long-term outcomes and return protection amid times of market stress.
What does this mean for long-term investors? First, they should carefully evaluate the role of bonds in their portfolio. Do they see this as a tool for diversification or to meet future liabilities? In addition, caution should be exercised when extrapolating the short-term diversification effects of an investment. Finally, the research highlights that the risk of short-term volatility is overshadowed by the long-term impact of inflation.
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