What is the Best Stock to Bond Ratio?
Answer – There isn’t one. It depends on your ability to withstand risk and volatility!
Risk and volatility are often used interchangeably in the financial press. Volatility is the measure of how far the price of an asset moves up or down, and risk is the chance of losing money - which means selling assets when the value has declined. If you do not need to sell and can wait the time needed to see out a market fall, then there is no risk.
Volatility of prices
Equities (stocks/shares) provide higher returns than Bonds but they are more volatile i.e. regular big ups and big downs in the value/purchase price and therefore more risk of loss if you need to sell. Bonds provide lower returns but with reduced volatility i.e. lower ups and downs and therefore less risk of loss. This is why we buy both Equities and Bonds. Equities and Bonds have a low correlation i.e. when Equities go down in value; Bonds tend to go up, and vice versa. By investing in a mixture of Equities and Bonds you can smooth the volatility and therefore the risk of loss.
How a different ratio of Stocks/Bonds affects Volatility
Let’s look at the effects of different Equity/Bond splits over the last 30 years. The data in the table is from 1986 to 2015. Equity is represented by the S&P 500 Index and Bonds are represented by five-Year US Treasury Notes:
(Remember, past performance is not indicative of future returns).
You can see that the rate of return increases as the proportion of Equities increases. Over the long-term, the more Equity you have in your portfolio, the more money you’re likely to have when you retire - but you need to be able to stick it out through some pretty rough patches to get those long-term returns.
You can see that the size of the ups and downs increases as the proportion of Equities increases. Standard deviation helps determine market volatility or the spread of purchase price from the average price. When prices move wildly, standard deviation is high, meaning more chance of losing money if you have to sell, or sell because you lose your nerve.
The table below shows the performance of the Vanguard LifeStrategy funds during the Covid pandemic:
During the pandemic, I rarely looked at my portfolio because I am a 'buy and hold' investor. I’m in it for the long term – investing not speculating. My portfolio is balanced with a mix of Equity and Bonds which provided a level of volatility I am comfortable with.
Many people listened to the financial media warning of catastrophe, and fear drove them to sell at a loss when the market was down. They were too heavily focused on Equity for their individual comfort levels and couldn’t take the wild ride. If they had taken a portfolio to a balance of Equity/Bonds that suited their risk profile they could have ridden out the storm. As you can see from the table above, the Covid stock market crash was very short-lived and the LifeStrategy funds recovered between 4 to 10 months later.
Some market crashes have lasted much longer. Between March 2008 and February 2009, the 100% Equity portfolio lost over 43% of its value. Even the 60% Equity portfolio lost over a quarter of its value in that same twelve-month period.
Between 2000 and 2002 (the aftermath of the Tech Bubble), the S&P 500 Index lost almost 38% of its value. Not as much as in 2008, but it was more spread out – the pain lasted three times as long and it was difficult for many investors to stay disciplined.
To get higher returns from Equity you need to be able to stay put even during the ugly times. Investing is about meeting your financial goals 10-30 years in the future, not getting the high score for this year, so making your portfolio match your risk tolerance is key to staying disciplined. You can work out your risk tolerance using internet tools – see the Vanguard website for example.
The 60/40 Portfolio
The 60/40 (Equities/Bonds) portfolio is the portfolio balance that the financial media often focus on – it is agreed to be the happy medium of investing portfolios. Its tilt towards Equities makes it pro-growth, but the significant slug in Bonds provides welcome relief during crashes when other investors flee to safer assets. This has worked extremely well over long periods of time; marginally underperforming a pure Equity portfolio but with something like 40% less volatility. Decent return and undisturbed sleep! Over the long term, Bonds will be a drag on performance but, if you think you might sell when (as will happen) the global stock market falls by 20%-50%, then you need Bonds.
Of course, all the figures discussed earlier are historical and cannot be relied on to happen in the future. Due to the low-interest rates currently from Bonds, some believe that the 60/40 fund will not make these kinds of returns in the future.
Diversification is still the answer
There is some worry that Bonds do not offer as much diversification or negative correlation from Equities as in the past. In the current market (June 2022) both Equities and Bonds are down in value since the start of the year – but I believe this is a short-term trend and could well change before the end of the year. In the past 20 years, the return correlation between Equities and Bonds has tended to move into positive territory for short periods, before reverting back to a negative state, if given enough time.
When central banks raise interest rates in response to increasing inflation, it causes Bond prices to fall as inflation erodes the fixed income they pay. Sometimes the price return can be negative but the total return positive - if the Bond pays enough interest. Still, Bonds are what you need in a portfolio when there is uncertainty, as a buffer, even when inflation is high.
Emergency fund saves the day!
In a climate where both Equity and Bonds are down and you need some ready cash – this is when your Emergency Fund comes into its own. You can leave both the Equity and Bonds to recover (hopefully Bonds recover fairly quickly) and spend on items planned for outside your regular income/expenditure budget, using your emergency fund.
At the start of your career, you should be aiming to have an emergency fund of around 3-6 months of income. By the end of your career, you should be aiming for 1-2 years’ worth of income so that you are protected from a market crash at retirement just as your working income stops and you are relying on your investment portfolio to provide an income.
The conventional wisdom today is that neither Equity nor Bonds will thrive in a low growth, high inflation environment. Yet, for a long-term investor, this is good news. Equity is currently cheaper than it was 6 months ago, so is effectively on sale! As for Bonds, rising interest rates provide higher guaranteed returns.
So the underlying principle of diversification, putting your eggs in more than one basket, is alive and well!