When the stock markets have long periods of positive returns, as they have had for most of the past decade, it can be easy to forget how a bear market feels to an investor. The last quarter of 2018 provided a vivid reminder. Large market swings and precipitous drops can unnerve even the most experienced investors, despite knowing that these swings are to be expected and are part of the reason that stock returns are generally higher than those of bonds. By comparison, bonds can seem boring, with their more stable, but lower, expected returns.
We know that risk and return are inextricably linked, and asset class correlation is a key factor in building a well-diversified portfolio. While expected returns on bonds are lower over the long term than stock returns, investors are often rewarded during down equity markets by the offsetting positive returns of bonds. This diversification dampens the overall volatility and makes market swings more tolerable. This was true in the 4th quarter of 2018, when the U.S. stock market posted a 14% loss, while the U.S. bond market was up.
Studies find that high-quality bonds provide ballast in volatile markets. This chart shows median returns of various asset classes during the worst decile of monthly U.S. equity returns, 1988-2017. It illustrates that the returns on high-quality bonds have been positive, on average, during months of the worst equity returns. Reducing volatility can improve outcomes for investors with shorter time horizons who are withdrawing from their portfolios.
“I like boring things,” pop artist Andy Warhol was fond of saying, referring to his use of mundane items in his art. In investing, as well as in art, boring can be beautiful.