Diversification is one of the best things you can do for a portfolio. Exposure to different asset classes can reduce risk, as each asset class reacts differently to market conditions.
But how differently do stocks and bonds really perform at given times? And what does it mean for investors?
Earlier this year, investors experienced negative returns (less than half a percentage point) over a 3-month period in both the U.S. stock and bond markets. It’s the first time that happened since October 2016.
Stocks and bonds usually move in opposite directions. When stocks do well, investors often move out of bonds. That can further boost stock prices. Yet a simultaneous loss in each asset class isn't unprecedented. In fact, it happens more often that you might think. Vanguard studied the monthly returns for the last 30 years (plus the first quarter of 2018). The goal was to see how often investors had seen a loss of value in either asset class.
Of the observed 363 months, the U.S. stock market lost value in a given calendar month 126 times, while the U.S. bond market lost value 112 times. Investors were almost as likely to see their bonds down in value as their stocks in any month. Still, the average stock market decline was –3.34 per cent, compared to only –0.70 per cent for the average bond decline.
Such simultaneous declines weren’t linked to a particular economic event. They happened during rising and falling rate environments alike, and during periods of robust market returns (like the late '90s tech boom) and periods of economic catastrophes (like the 2008 global financial crisis).
For investors, the good news was the median return for the 12 months after the simultaneous decline was 12.17 per cent for stocks and 8.18 per cent for bonds. Yet the question remains: are investors susceptible and, if so, how can they hedge their bets?
To find out, Vanguard analyzed various economic indicators using its Vanguard Capital Markets Model® to project how future outcomes can vary for investors. Vanguard simulated 10,000 scenarios for each asset class out to 2027. Then Vanguard focused on the bottom 10 per cent of the lowest-performing quarters for the global equity7 asset class for each simulation.
Using this forward-looking approach, Vanguard found that inflation hedges like commodities and real estate investment trusts (REITs) failed to mitigate global equity volatility. During periods of poor equity performance, interest rate hedges like cash and short-term bonds produced only minimal positive returns.
The smartest hedging strategies? Vanguard says that broad-based exposure to high-quality international and U.S. fixed income provided the greatest likelihood of positive returns to reduce global equity losses.
The best course for investors is to maintain an asset allocation in line with their goals and risk tolerance. Then, if they drift more than about 5 percentage points from their target asset allocation, rebalance the portfolio. Resist the temptation, Vanguard argues, to make aggressive investment shifts or to look for a quick fix for equity volatility.
No one can say which, if any, of the possible outcomes Vanguard simulated will become reality over the next decade. The classic inverse relationship between stocks and bonds appears to hold up in most simulations. Still, we’ll likely see short periods when it doesn’t. These exceptions to the norm shouldn’t lead investors to abandon their long-term investment strategy.
This content was produced by Vanguard. The Globe and Mail was not involved in its creation.