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Assuming that the money invested is not to be touched for decades (so the risk of temporary market downturns is irrelevant in this case), many suggest that you should still diversify your portfolio with say: 20% bonds and 80% stocks.

Now, one of the biggest reasons in favor of this, is that during stock market lows, you have a bunch of money in bonds that you can throw into stocks while their prices are low (usually when you rebalance).

However, periods of stock market downturns are far shorter and less often than periods of regular stock market growth. During the latter, you're losing on higher returns by not having that 20% in stocks.

So, is there any data available that shows hypothetical portfolios with this kind of diversification outperforming all-stock kind of portfolios over the years?

  • I think your premise (that the primary reason for diversification is to keep money in reserve) is incorrect. One reason to diversify is so that if you ever need to withdraw money you have choices on how to do it. If you have an oracle that can tell you right now that investment A is always going to do better than investment B and that there's no way in which the money you have invested in B could ever be more helpful to you than the money you have in A -- then don't invest in B. The problem is that there is no such oracle, so having some money in bonds might help you some day. – dg99 Mar 13 '15 at 22:01
  • @dg99 That Oracle could be the past. In the long term, stocks will always outperform bonds; otherwise there wouldn't be a reason to be exposed to the higher risk that stocks come with. – AxiomaticNexus Mar 13 '15 at 22:22
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    @YasmaniLlanes: The oracle of the past doesn't tell you whether you're going to need the money at a time when the market is down. You can say "I don't need the money for decades", but you can never know that with 100% certainty. Also, even if you don't need it for decades, if it goes down just when you need it, you'll still be a in a tough spot. – BrenBarn Mar 14 '15 at 3:14
  • @BrenBarn This is money in a retirement account. Taking it out before I retire would cost me a lot of money in fees, penalties and taxes. There's no way I'm touching it. Assuming that I never touch it, would I be better off with the all-stock approach? – AxiomaticNexus Mar 14 '15 at 21:43
  • If your question is just "why would I ever invest in bonds", see this question. – BrenBarn Mar 14 '15 at 21:48
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This paper by a Columbia business school professor says:

The standard 60%/40% strategy outperforms a 100% bond or 100% stock strategy over the 1926-1940 period (Figure 5) and over the 1990-2011 period (Figure 6).

This is based on actual market data from those periods. You can see the figures in the PDF. These are periods of 14 and 21 years, which is perhaps shorter than the amount of time money would sit in your IRA, but still a fairly long time. The author goes on with a lot of additional discussion and claims that "under certain conditions, rebalancing will always outperform a buy-and-hold portfolio given sufficient time".

Of course, there are also many periods over which a given asset mix would underperform, so there are no guarantees here. I read your question as asking "is there any data suggesting that rebalancing a diversified portfolio can outperform an all-in-one-asset-class portfolio". There is some such data. However, if you're asking which investing strategy you should actually choose, you'd want to look at a lot of data on both sides. You're unlikely to find data that "proves" anything conclusively either way.

It should also be noted that the rebalancing advantage described here (and in your question) is not specific to bonds. For instance, in theory, rebalancing between US and international stocks could show a similar advantage over an all-US or all-non-US portfolio.

The paper contains a lot of additional discussion about rebalancing. It seems that your question is really about whether rebalancing a diverse portfolio is better than going all-in with one asset class, and this question is touched on throughout the paper. The author mentions that diversification and rebalancing strategies should be chosen not solely for their effect on mathematically-calculated returns, but for their match with your psychological makeup and tolerance for risk.

  • My own study concluded that the 70/30 or 60/40 mix lower return ever so slightly, but reduced volatility by a significant amount. The period was 1972-2008 in my article Diversifying to Reduce Risk – JTP - Apologise to Monica Mar 14 '15 at 23:16
  • Note that a standard tool for evaluating this sort of thing is monte-carlo simulation of the market, which really does yield pretty credible estimates of risk vs. return. – keshlam Mar 15 '15 at 5:34
  • @JoeTaxpayer If these are the only two periods when mixed portfolios have outperformed all-stock ones, I'm still not convinced. It's just that the periods in which the opposite occurs are so much longer. I just don't think that less volatility in exchange for lower returns is of any value to truly pragmatic people who won't touch that money during market lows. I would go for the mixed approach only if it was just as likely to give higher returns as an all-stock one; only then would it be worth it since it would give you less volatility "free of charge". Am I talking crazy here? – AxiomaticNexus Mar 17 '15 at 20:44
  • @YasmaniLlanes: I think that is really a separate question. For almost any pair of investment strategies, you can find some period over which one beats the other. The question is how well the strategy's performance matches what you want out of it (e.g., minimizing losses vs. maximizing gains), as well as how well-motivated it is (i.e., I would be leery of a strategy with great performance but no explanation for how it is achieved). Like I said in my answer, the question of "is there data showing strategy X outperforms Y?" is not the same as "should I personally choose X or Y?". – BrenBarn Mar 17 '15 at 20:44
  • @BrenBarn I just want to make sure my reasoning is not as stupid as that of someone who would put all their money on a single stock. I just want to make sure this strategy is not unreasonable in your opinion. – AxiomaticNexus Mar 17 '15 at 20:57

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