Diversification, Justification

Most people understand that a properly diversified portfolio will include multiple asset classes and will have several different types of investments. They also understand that the performance of these various asset classes should not always move in lockstep (hence, the benefits of diversification and non correlated assets). However, years like 2013 test an investor’s ability to stick with their asset allocation model. Why? Because in 2013, not only have we seen great degrees of variance among different equity classes (example: Domestic Large Cap Equities (SPY) up +17.67% YTD and Emerging Market Equity (EEM) down -10.02% YTD), but we’ve also seen great variances in the performance of equities vs. fixed income (example: Domestic Large Cap Equities (SPY) +17.67% and the Barclay Aggregate Index (AGG) -4.11%).

All that being said, it makes sense that an immediate end to the Fed’s policies would hurt bond returns in the short term, but help in the long term. While rising interest rates initially push down bond prices, they also increase expected returns from income thereafter. The pain from the price drop comes quickly, while the benefit of higher income accrues gradually over time.

Traditionally, most investors have owned bonds for income and stability, and to diversify equity-market risk. Short-term interest rates near zero and quantitative easing have pushed yields (especially Treasuries) to historic lows, so higher yields should be welcomed by most investors. These low rates have also created the potential for instability when the Fed Policies end, but the diversification benefit of bonds remains strong. Stability, cash flow support, and certainty are just a few of the benefits in having an allocation to bonds.

Whether to own bonds or stocks should not be a yes-or-no question. A properly diversified portfolio should almost always include both. Just as investors should have held onto their equity (stock) allocation through the downturn in 2008, today, investors should stay the course and remember why they have an allocation to bonds as well.

Performance numbers through 9/5/13

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