We’ve now talked about all four factors that have been shown to correlate with higher returns in the stock market.
The market (beta), value, size, and momentum factors; we’ve covered them all. It may have been a little bit econ 101, but it was probably necessary in order to frame the next part of our discussion.
If we want to diversify between different segments of the stock market, in order to increase the efficiency and returns of our portfolio, we may as well cherry pick the segments of the market which correlate poorly with each other, and have increased expected returns.
But before we get on to the fun task of selecting funds and investment strategies, there’s one more arena of investments that we should cover: fixed income.
Fixed income refers to bonds, or debt instruments.
When you invest in a stock you’re buying a small piece of a company. When the company grows, your stock grows. The company may sometimes pay dividends from its profits to you, the investor, but it isn’t required to do so.
When you purchase a bond, you are essentially loaning an entity (country, municipality, or company) money. In exchange for the loan, the entity promises to pay your principle back as well as the interest on it.
It’s called “fixed income” because for the life of the bond, the bond purchaser will be paid a fixed rate of interest which is agreed to at the time of the bond purchase.
The bond’s market value can change, based mostly on changes in interest rates. As an example, if you buy a bond that pays 3% interest (also known as a coupon of 3%), and interest rates subsequently go up so that bonds of the same duration now are being offered at an interest rate of 4%, then if you want to sell your bond you will have to sell it at a discount. But when the bond comes to term the principal amount will still be paid back in full. This concept is very well described in this excellent series of educational videos from Khan Academy:
The ratio of a bond’s coupon rate to its underlying value is known as the yield. Since the coupon rate is constant, then as the value of the bond goes down, the yield must go up (and vice versa.)
There are several general qualities that make fixed-income an important part of almost every portfolio.
1. In general, bonds have less risk than stocks. (bonds have less volatility.) This is particularly true of United States treasuries, and short-term high quality investment grade bonds.
2. Because they have less risk, there’s less expected return.
3. Short-term investment-grade bonds and US treasuries are poorly correlated with stocks making them an excellent diversifier.
4. There are classes of bonds known as high-yield or junk bonds. These have higher returns because they are more risky. Unfortunately the risk tends to show up at the same time stocks tend to do badly, making them poor diversifiers.
My take on bonds is that they function as a solid foundation to most portfolios.
The inclusion of high-quality bonds in a portfolio tends to limit its overall risk, which in turn limits both the downside, and the upside potential.
Bonds will be a drag on your portfolio when the stock market is doing well. But they will be a lifesaver to your portfolio when the stock market is crashing.
When you are young and accumulating money, you need less of a foundation. Your portfolio is a skyscraper being built. You’re not so much trying to protect your wealth as trying to grow it. As such, you will want less bonds in your portfolio.
wealth accumulation: less bonds
When you’re older, or in retirement, you will want to protect your wealth. Your portfolio will be more like a bunker than a skyscraper. You ‘ll want to shield your wealth from drastic losses. As such fixed income will play a much more prominent role in your portfolio.
wealth protection: more bonds
So why should a young investor not just put all of his eggs in the stock market basket?
The answer has to do with limiting volatility and rebalancing.
Imagine you had a portfolio of $100,000 invested entirely in stocks in 2007 right before the market crashed.
With the crash The value would plummet down 50% to a value of $50,000 at it’s lowest. The stock market would then start climbing again and by 2010 you would probably have recovered back to a value of about $100,000.
But what if you had had a 25% Bond/75% stock portfolio ?
At times of financial crisis money tends to flee the stock market and into high-quality bonds. This is called “flight to quality.” This raises the value of bonds.
But let’s just conservatively say that the bonds held stable value at the time of the crash.
So the $25,000 of bonds is still worth 25,000 dollars. And at the lowest point in the stock market , the $75,000 of stocks loses 50% and is now worth $37,500 dollars. So entire portfolio is now worth $62,500. 40% of this is now bonds.
So what do you do? You rebalance.
You sell $9375 of your bonds in order to buy stocks. And remember, you’re buying socks at a discount since they have just suffered a big hit.
So now you have $46,875 worth of stocks, and $15,625 worth of bonds.
Then both the bonds and the stocks start increasing in value. But for the sake of making our argument even more convincing, we will just say that the bonds maintain their same value.
So in 2010 the stocks have doubled to a value of 93,750. And the bonds are still worth $15,625.
So now your portfolio is worth $109,375 or almost nine and a half percent more than the 100% stock portfolio at the same time.
This is because the bonds both cushioned the fall from the initial stock-market crash, as well as provided us with a reservoir of capital to buy devalued stocks with, at a cheaper price.
There is no one formula to determine how much of your portfolio should be in bonds versus stocks.
A good place to start, however, would be your age in bonds, or your age -10 in bonds.
So a 40-year-old investor would have either 40 or 30% of his portfolio in bonds, and 60 or 70% in stocks, depending on his appetite for risk/reward.
