Rethinking Portfolio Diversification

Bear

Portfolio diversification is a tried-and-true way to limit the ups and downs in a portfolio. Historically, the best way to diversify stock risk is to own bonds. The consistent income stream and penchant to rise in value when stocks decline make bonds a valuable diversifier, especially during bear markets. But the relentless decline in bond yields over the past 40 years appears to have reached its limit. The current recession prompted the Federal Reserve to lower rates to an extent that pushed 30-year Treasury yields below 1 percent. Bond values rise as rates fall, so as yields move toward zero, the ability of bonds to generate positive returns when stocks decline becomes limited. This phenomenon is evident in Figure 1, which shows the drawdown history of a 60 percent S&P 500, 40 percent 10-year Treasury portfolio. This portfolio just experienced one of its worst months of performance since the 1960s, partly due to the lessened ability of bonds to protect the portfolio. Figure 2 shows the performance of the S&P 500 during the last two recessions, as well as the February to March 2020 period. This chart also reflects the diminished ability of bonds to cushion downside. Treasuries provided less than half the return of prior bear markets, resulting in a more significant decline for the balanced portfolio. 

Figure 1: Drawdowns for a 60% U.S. Stock/40% Bond PortfolioFigure 1: Drawdowns for a 60% U.S. Stock/40% Bond PortfolioFigure 2: Stock & Bond Returns During Recent Bear Markets
Stock & Bond Returns During Recent Bear Markets

Given this, what is the best way to diversify a portfolio going forward? Bonds will continue to play a role but will likely provide a reduced benefit going forward. The stock outlook has been boosted by the fall in rates, but buying more stocks increases risk. One area of opportunity involves strategies that are exposed to stock returns but with built-in risk reducers, or hedges. Examples include strategies that use options to manage risk and minimum volatility stock funds to help tame portfolio value swings. These strategies should provide better returns than bonds without the full downside risk of stocks in normal market declines.  

Another way to add diversification would be via real assets, including certain commodities. The post-COVID-19 portfolio will have to deal with a world awash in cash, as central banks have turned on their “printing presses” to combat the recession. Real assets can help fill the diversification gap left by bonds in a zero interest rate world. While nothing will ever replace bonds as the ultimate diversifier, these strategies can help bolster a portfolio’s resilience and return in the new investing landscape. Please consult with your investment advisor to determine what strategy is right for your individual situation. 

BKD Wealth Advisors, LLC is an SEC-registered investment adviser offering wealth management services for affluent families and investment consulting services for institutional clients and is a wholly owned subsidiary of BKD, LLP. The views are as of the date of this publication and subject to change. Different types of investments involve varying risks, and it should not be assumed that future performance of any investment or investment strategy or any noninvestment-related content will equal historical performance level(s), be suitable for your individual situation or prove successful. A copy of BKD Wealth Advisors’ current written disclosure statement is available upon request.

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