Using balance to ride out volatility
During the recent period of poor stock market performance, balanced portfolios dampened the effects of the market's losses and volatility-exactly as they were supposed to. 2002 marked the third consecutive down year for the U.S. stock market and the market's worst year since 1974. Both the value and growth domains were hit, as were non-U.S. stocks. In the face of this, a central investing tenet proved its value: Combining low-correlated asset types in an investment portfolio afforded investors competitive returns with less risk.
The Phenomenon of Low Correlation
In statistics, correlation measures the relationship between two entities. A correlation of 1.0 means that the two entities move in perfect tandem with each other. A correlation of zero means the relationship between them is totally random. A negative correlation, unusual in the investing world, means that they move in opposite directions. In investing, a low correlation means that different asset types have not performed in the same way: When returns on some asset types decline, returns on others decline less, or indeed gain. For investors, this diversification has obvious benefits. If poor performance in one investment can be offset by better (or even good) performance in another, extreme losses in an overall portfolio will be rarer than otherwise, and the capital will grow more in the long run.
For most investors, the classic combination of stocks and bonds is where lowcorrelation investing begins. Over time, stocks have earned more than bonds, but because bonds have not been highly correlated to the stock market, they have played a critical role in offsetting equity risk.
For example, consider six different portfolios of stocks and bonds over three time periods, 1991 to 2002 and the subperiods 1995 to 1999 and 2000 to 2002 (see Exhibit 1). From 1991 through 2002, an all-bond portfolio returned 8.2% and an all-stock portfolio returned 10.8%, strong returns for both. Although stocks out-performed bonds by 2.6 percentage-points, somewhat lower than the historical average, the spread in annualized risk from 3.7% for the all-bond portfolio to 15% for the all-stock portfolio was consistent with history. (Risk is measured by volatility of returns; how much they deviate from one another over time.)However, this risk/return relationship masks the fluctuations investors experienced over the course of those dozen years.
Looking at the 1995 to 1999 and 2000 to 2002 periods shows how variable the risk/return of stocks and bonds can be in the short term. Over the 1995 to 1999 period, stocks returned 28.5% and bonds returned only 7.7%. Investors were handsomely rewarded for taking on more stock exposure, and many began to give up on bonds. With stock returns so strong, few investors worried about risk. However, in the three-year period immediately following, 2000 to 2002, investors experienced a total reversal. A heavy stock allocation would have punished returns, while bonds were clearly the way to weather the bear market.
The timing and magnitude of expected short-term shifts are impossible to predict, and changing asset allocation to capitalize on short-term shifts is never prudent. The best strategy to maximize long-term return potential and minimize risk is to hold a combination of low-correlating assets.
One might say the problem with combining stocks and bonds is that adding bonds to a stock portfolio will systematically lower its long-term return. But smoothing the variability in year-to-year returns over time by combining these low-correlated assets can reward the long-term investor. In the 1991 to 2002 period, for example, a portfolio of 60% stocks and 40% bonds provided returns competitive with 100% stocks, yet did so with much lower levels of risk.
The 60/40 combination is worth a deeper look. The return of this portfolio from 1991 to 2002 was 10%. Yet this same combination returned 20% in the roaring bull market of 1995 to 1999 and lost only 4. …