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Why Are Bonds a Useful Diversifier?

A reader writes in, asking:

“I graduated in May and immediately started contributing to the 401k at my new job. Fidelity runs the 401k. I am using the Spartan 500 Fund, the Spartan U.S. Bond Fund, and a small amount in the Total International Equity Fund.

I thought my portfolio was diversified. But the Spartan 500 fund went way down last month and the U.S. Bond fund barely went up at all. I’ve read that ‘bonds zig when stocks zag’ but that doesn’t seem to be working. Do you have any suggestions?”

The problem doesn’t appear to be with the portfolio. A portfolio of those 3 funds would be reasonably well diversified. The problem is that you’re expecting too much from your bond holdings.

Historically in the U.S., bonds have typically had a positive correlation to stocks. (See Figure 2 in this paper from Vanguard.) In addition, the correlation between stocks and bonds varies dramatically over time. (See Figure 1 in this article from Rick Ferri.)

In other words, the reason bonds are a successful diversifier is not that they have negative correlation to stocks and that you can expect bonds to rise reliably when stocks fall. Sometimes it works out that way, and it’s very convenient when it does. But you can’t count on it.

The primary reason that bonds work well as a diversifier is simply that they are less risky than stocks. That is, when stocks are falling, it’s entirely possible that bonds will be falling too. But as long as you’ve stayed away from very high-risk bonds (e.g., junk bonds or bonds with very long durations), it’s very unlikely that your bonds will fall as much as your stocks.

For example, the following chart (made using the Morningstar website), shows the returns of Vanguard Total Stock Market Index Fund (in blue) and Vanguard Total Bond Market Index Fund (in orange) over the last three months.

Screen Shot 2015-09-27 at 8.48.22 AM

As you can see, the stock fund fell quite noticeably around the middle of August. The bond fund didn’t shoot upward when the stock fund fell, but it didn’t decline precipitously either. That’s pretty much what you should be hoping for from a bond fund. It delivers boring, low-risk performance, even when stocks are performing poorly.

If you’re hoping that your bond holdings will reliably offset any stock losses that you experience, thereby allowing your portfolio to climb steadily upward without any bumps, you’re going to be disappointed.

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