HAVENS & HELL

Diversification often means having to say you’re sorry. With a truly diversified portfolio, there is usually something you own that’s doing poorly. If every piece of your portfolio is doing well, you are either very lucky or you are not truly diversified.

There’s a popular belief that bonds (“fixed income”) provide ample portfolio diversification. So much, in fact, that trillions of dollars are allocated to fixed blends of stocks and bonds. The implementation of 50/50, 60/40, 70/30 blends of stocks and bonds is widespread industry practice. Bonds are widely considered a haven asset.

But what happens when the haven goes to hell?

There is a fallacy of logic which manifests among investors as a behavioral bias in favor of bonds. This happens when people erroneously extrapolate the characteristics of the component (i.e., a bond fund’s volatility) up to the aggregate level (i.e., the portfolio’s riskiness) without accounting for how the components are arranged within the aggregate.

Here's an example: bond fund A is less volatile than bond fund B, so a portfolio containing bond fund A must be less volatile than a portfolio containing bond fund B. The error here is that the interaction between bond fund A and the rest of the portfolio is being ignored.

Correlations between asset classes are not static – they can and do change over time. Placing responsibility for diversification onto a single source can backfire when historical correlations change. There is no reason to believe one can predict future correlations any better than one can predict future returns.

A 40-year bull market in bonds has bolstered the belief that bonds are safe. In the early 1980’s, the yield on a 10-year US Treasury bond was over 15%. It fell as low as 0.5% in 2020, as global central banks flooded the system with stimulus. This of course followed trillions of dollars in bailouts from the Financial Crisis a decade ago.

In the early days of the pandemic, the US Federal Reserve nationalized the bond market, buying Treasuries and numerous fixed-income ETF’s. The ensuing ‘Everything Bubble’ (stocks, bonds, real estate) is classic monetary inflation. Yet since it boosts asset prices, you don’t hear many complaints.

Today we are seeing a resurgence of classic inflation. The recent CPI print of 8.5% was the highest since the 1980’s. It creates a tough environment for bonds, which have ceased to function as an adequate haven from declining stocks.

Bond returns are largely negative since last summer. The price of a 10-year Treasury has dropped over 11%, the 30-year Treasury is off over 17% just this year, and 1-3-year Treasuries are down about 3.5%. Even TIPS are a false promise. Supposedly inflation-protected, they are negative as well. The havens are getting hammered.

The chart below demonstrates the rout in bond-land.

This may, of course, change. Regardless, it’s time to re-consider traditional asset allocation and fixed weightings of stocks and bonds.

Some, no doubt, blame recent market turmoil on the Ukraine war. But as we’ve shown, rates have been rising for eight months, and stocks bottomed on February 24, the day of the Russian invasion.

Diversification is still the best tool for maximizing investor outcomes, but the concept of diversification must be broadened. De-risking a portfolio shouldn’t be left solely to bonds. Sensible alternative strategies include long/short equity, adaptive asset rotation, and hedging. Also, in an environment such as this, cash is a viable asset class.

Proper diversification means never having to say you’re sorry.

Stocks/Bonds 60/40 Portfolio Asset Allocation

BND 40% Vanguard Total Bond Market ETF

VTI 60% Vanguard Total Stock Market ETF

As of Apr 9, 2022, the 60/40 Portfolio returned -7.15% Year-To-Date and 9.53% of annualized return in the last 10 years.

1M YTD 6M 1YR

2.49% -7.15% -3.33% 1.73%

The SHARPE RATIO shows whether a portfolio's returns are due to smart investment decisions or a result of taking higher risk. The higher the ratio, the better its risk-adjusted performance.

The current 60/40 Portfolio Sharpe ratio is 0.10. A Sharpe ratio between 0 and 1.0 is considered sub-optimal.

Maximum drawdown measures the reduction in portfolio value from its maximum due to a series of losing trades. The max drawdown since 2010 for the 60/40 Portfolio is -21.85%, recorded on Mar 22, 2020. It took 79 trading sessions for the portfolio to recover.

Source: Portfolios Lab