Investing in Bonds

Bonds are a common investment for people targeting a low-risk investment portfolio. One of the pieces of advice I gave my kids (see others in this post) is to never buy anything you don’t understand. In this post, I’ll tell you what you need to know so you can decide whether investing in bonds is appropriate for you.

What is a Bond?

A bond is a loan you are giving the issuer.  The parties to the transaction are exactly opposite of you taking out a loan. You’ll see the parallels if you compare the information in this post with that provided in my post on loans!  When you buy a bond, you are the lender.  The issuer of the bond is the borrower.

How Do Bonds Work?

The issuer of a bond sells the bonds to investors (i.e., lenders).  Every bond has a face amount.  Common face amounts are $100 and $1,000.  The face value of the bond is called the par value.  It is equivalent to the principal on a loan.  When the issuer first sells the bonds, it receives the face amount for each bond.

The re-payment plan for a bond is different than for a loan.  When you take out a loan, you make payments that include interest and a portion of your principal.  Over the life of your loan, all of your payments are the same (unless the interest rate is adjustable).   By comparison, a bond issuer’s payments include only the interest until the maturity date when it pays the final interest payment and returns the principal in full.

Before selling bonds, the issuer sets the coupon rate and the maturity date of the bond.  The coupon rate is equivalent to the interest rate on a loan.  The maturity date is the date on which the issuer will pay the par value to the owner of the bond.  It can vary from something very short, like a year, all the way to 30 years.  In Europe, there are even bonds with maturity dates in 99 years.  In the meantime, the issuer will pay coupons (interest) equal to the product of the coupon rate and the par value, divided by the number of coupons issued per year. Coupons are often issued quarterly. For example, if you owned a bond with a $1,000 par value, a 4% coupon rate and quarterly payments, you would get 1% of $1,000 or $10 a quarter in addition to the return of the par value on the maturity date.

What Price Will I Pay

You can buy bonds when they are first issued from the issuer or at a later date from other people who already own them.  You can also sell bonds you own if you want the return of your initial investment before the bond matures.  If you buy and sell bonds, the sale prices will be the market price of the bonds.

Present Value

Before explaining how the market value is calculated, I need to introduce the concept of a present value. A present value is the value today of a stated amount of money you receive in the future.  It is calculated by dividing the stated amount of money by 1 + the interest rate adjusted for the length of time between the date the calculation is done and the date the payment will be received.  Specifically, the present value at an interest rate of i of $X received in t years is:

The denominator of (1+i) is raised to the power of t to adjust for the time element.

Market Price = Present Value of Cash Flows

The market price of a bond is the present value of the future coupon payments and principal repayment at the interest rate at the time of the calculation is performed.

Interest Rate = Coupon Rate When Issued

The interest rate when the bond is issued is the coupon rate!  Because the issuer sells the bonds at par value (the face amount of the bond), the par value has to equal the market value.  For the math to work, the coupon rate must equal the interest rate at the time the bond is initially sold.

Interest Rates after Issuance

If interest rates change (more on that in a minute) after a bond is issued, the market value will change and become different from the par value because the “i” in the formula above will change.  When the interest rate increases, the price of the bonds goes down and vice versa.

Also, as the bond gets closer to its maturity date, the exponent “t” in the formula will get smaller so it will have less impact on the present value, making the present value bigger. As such, all other things being equal, a bond that has a shorter time to maturity will have a higher market price than a bond that has a longer time to maturity.  Remember that the par value is all paid at the end, so the market price formula is highly influenced by the present value of the repayment of the par value.

How is the Interest Rate Determined

There are two factors specific to an individual bond that influence the interest rate that underlies its price – the bond’s time to maturity and the issuer’s credit rating. In addition, there are broad market factors that influence the interest rates for all bonds.  These factors influence the overall level of interest rates as well as the shape of the yield curve.

What is a Yield Curve

The interest rate on a bond depends on the time until it matures.  If I look at the interest rates on US government bonds today (March 7, 2019) at this site, I see the following:

The line on this graph is called a yield curve.  It represents the pattern of yields by maturity.  In this case, there is some variation in yields up to 5 years and then the line goes up.

A “normal” yield curve would go up continuously all the way from the left to the right of the graph.  Up to five years, the chart above would be considered essentially “flat” and, above five years, would be considered normal.  If the entire yield curve went down, similar to what we see in the very short segment from one year to two years in this graph, it would be considered inverted.

Time to Maturity

The yield curve along with the maturity date of a bond influencethe interest rate and therefore its market price.  Looking at US Government bonds, the interest rates for bonds with maturities between 0 and 7 years are all around 2.5%.

The price of a 30-year bond will reflect interest rate of about 3%.  If the yield curve didn’t change at all, the same 30-year bond would be priced using a 2.5% interest rate in 23 years (when it has 7 years until maturity).  With the lower interest rate, the market value of the bond will increase (in addition to the increase in market value because the maturity date is closer).

Credit Rating

The other important factor that affects the price of a bond is its credit rating.  Credit ratings work in the same manner as your credit score does.  If you have a low credit score (see my post on credit scores for more information), you pay a higher interest rate when you take out a loan.  The same thing happens to a bond issuer – it pays a higher interest rate if it has a low credit rating.

Instead of having a numeric credit score, bonds are assigned letters as credit ratings.  There are several companies that rate bonds, with Standard and Poors (S&P), Moodys and Fitch being the biggest three.    When you buy a bond (more on that later), the credit rating for the bond will be quite clearly stated.

The graph below summarizes information I found on the website of the St. Louis Federal Reserve Bank (FRED).

It shows the interest rates on corporate bonds with different credit ratings on February 28, 2019. As you can see, there is very little difference in the interest rates of bonds rated AAA, AA and A, with a slightly higher interest rate for bonds rated BBB.  Bonds with BBB ratings and higher are considered investment grade.

Bonds with ratings lower than BBB are called less-than-investment grade, high yield or junk. You can see that the interest rates on bonds with less-than-investment grade ratings increase very rapidly, with C-rated bonds having interest rates close to 12%.

What are the Risks

There are two risks – default and market – that are inherent in bonds themselves and a third – inflation – related to using them as an investment.

Defaults

Default risk is the chance that the issuer will default or not make all of its coupon payments or not return the full par value when it is due.  When an issuer defaults on a bond, it may pay the bond owner a portion of what is owed or it could pay nothing.  The percentage of the amount owed that is not repaid is called the “loss given default.”  If the loss given default is 100%, you lose the full amount of your investment in the bond, other than coupon payments you received before the default.  At the other extreme, if the loss given default is only 10%, you would receive 90% of what is owed to you.

Issuers of bonds with low credit ratings are considered riskier, meaning they are expected to have a higher chance that they will default than issuers with high credit ratings. I always find this chart from S&P helpful in understanding default risk.

It shows two things – the probability of an issuer defaulting increases as the credit rating gets lower (e.g., the B line is higher than the A line) and the probability of default increases the longer the time until maturity.

These increases in the probability of default correspond to increases in risk.  Recall from the previous section that interest rates increase as there is a longer time to maturity when the yield curve is normal and as the credit rating gets lower. The higher interest rates are compensation to the owner of the bond for the higher risk of default.

When you read the previous section and saw you could earn between just under 12% on a C-rated bond, you might have gotten interested.  However, it has almost a 50% chance of defaulting in 7 years!  The trade-off is that you’d have to be willing to take the risk that the issuer would have a 26% chance of defaulting in the first year and a 50% chance by the seventh year!  It makes the 12% coupon rate look much less attractive.

Changes in Market Value

As I mentioned above, you can buy and sell bonds in the open market as an alternative to holding them to maturity.  In either case, you will receive the coupon payments while you own the bond, as long as the issuer hasn’t defaulted on them.  If you buy a bond with the intention of selling it before it matures, you have the risk that the market value will decrease between the time you purchase it and the time you sell it.  Decreases in market values correspond to increases in interest rates. These increases can emanate from changes in the overall market for bonds or because the credit rating of the bond has deteriorated.

If you hold a bond to maturity and it doesn’t default, the amount you will get when it matures is always the principal.  So, you can eliminate market risk if you hold a bond to maturity.

Interest Doesn’t Keep Up with Inflation

The third risk – inflation risk – is the risk that inflation rates will be higher than the total return on the bond.  Let’s say you buy a bond with a $100 par value for $90, it matures in 5 years and the coupons are paid at 2%.  Using the formulas above, I can determine that your total return (the 2% coupons plus the appreciation on the bond from $90 to $100 over 5 years) is 4.3%.  You might have purchased this bond as part of your savings for a large purchase.  If inflation caused the price of your large purchase to go up at 5% per year, you wouldn’t have enough money saved because your bond returned only 4.3%.  Inflation risk exists for almost every type of invested asset you purchase if your purpose for investing is to accumulate enough money for a future purchase.

How are They Taxed

There are two components to the return you earn on a bond – the coupons and appreciation (the difference between what you paid for it and what you get when you sell it or it matures).

Tax on Coupons and Capital Gains

The coupons are considered as interest in the US tax calculation.  Interest is included with your wages and many other sources of income in determining your taxes which have tax rates currently ranging from 10% to 37% depending on your income.

The difference between your purchase price and your sale price or the par value upon maturity is considered a capital gain.  In the US, capital gains are taxed in a different manner from other income, with a lower rate applying for most people (0%, 15% or 20% depending on your total income and amount of capital gains).

States that have income taxes usually follow the same treatment with lower tax rates than the Federal government, but not always.

Some Bonds are Taxed Differently

Within this framework, though, not all bonds are treated the same.  The description above applies to corporate bonds.  Bonds issued by the US government are taxed by the Federal government but the returns are tax-free in most states.

Some bonds are issued by a state, municipality or related entity.  The interest on these bonds is not taxed by the Federal government and is usually not taxed if you pay taxes in the same state that the issuer is located.  Capital gains on these bonds are taxed in the same manner as corporate bonds.

Included in this category of bonds are revenue bonds. Revenue bonds are issued by the same types of entities, but are for a specific project.  They have higher credit risk than a bond issued by a state or municipality because they are backed by only the revenues from the project and not the issuer itself.

The manner in which a bond is taxed is important to your buying decision as it affects how much money you will keep for yourself after buying the bond.  You should consult your broker or your tax advisor if you have any questions specific to your situation.

Do They Have Other Features

If you decide to buy bonds, there are some features you’ll want to understand or, at a minimum, avoid. Some of the types of bonds with these distinctive features are:

Treasury Inflation-Protected Securities or TIPS

TIPS are similar to US Government bonds except that the par value isn’t constant.  The impact of inflation as measured by the Consumer Price Index is determined between the issue date and the maturity date.  If inflation over the life of the bond has been positive, the owner of the bond will be paid the original par value adjusted for the impact of inflation.  If it has been negative, the owner receives the original par value.  In this way, the owner’s inflation risk is reduced.  It is completely eliminated if the owner purchased the bond to buy something whose value increases exactly with the Consumer Price Index.

Savings or EE Bonds

Savings bonds are a form of US Government bond.  You can buy them with par values of as little as $25.  They can be purchased for terms up to 30 years.  Currently, savings bonds pay interest a 0.1% a year.  The interest is compounded semi-annually and paid to the owner with the par value when the bond matures.   With the currently very low interest rates, these bonds are very unattractive.

Zero-Coupon Bonds

The issuer of a zero-coupon bond does not make interest payments.  Rather, when it issues the bond, the price is less than the par value. In fact, the price is the present value of just the principal payment.  So, instead of paying the par value for a newly issued bond and getting coupon payments, the buyer pays a much lower price and gets the par value when the bond matures.

I don’t know all the details, but believe that, in the US, the owner needs to pay taxes on the appreciation in the value of the bond every year as if it were interest and not as a capital gain on sale.  As such, it is better to own a zero-coupon bond in a tax-deferred or tax-free account, such as an IRA, a 401(k) or health savings account.  I’ve owned one zero-coupon bond – it was my first investment in an IRA.  If you want to buy a zero-coupon bond, I suggest talking to your broker or tax advisor to make sure you understand the tax ramifications.

Callable Bonds

A call is a financial instrument that gives one party the option to do something.  In this case, the issuer of the bond is given the option to give you the par value earlier than the maturity date.  When the issuer decides to exercise this option, the bond is said to be “called.”  The bond contract includes information about when the bond is callable and under what terms. If you purchase a callable bond, you’ll want to understand those terms.

Issuers are more likely to call a bond when interest rates have decreased. When interest rates go down, the issuer can sell new bonds at the lower interest rate and use the proceeds to re-pay the callable bond, thereby lowering its cost of debt.

In a low-interest rate environment, such as exists today, a callable bond isn’t much different from a non-callable bond as it isn’t likely to get called.  If interest rates were higher, a non-callable bond with the same or similar credit quality and coupon rate is a better choice than a callable bond. If the callable bond gets called, you will have cash that you now need to re-invest at a time when interest rates are lower than when you initially bought the bond.  (Remember that the reason that callable bonds get called is that interest rates have gone down.)

Convertible Bonds

Convertible bonds allow the issuer to convert the bond to some form of stock.  As will be explained below, stocks are riskier investments than bonds.  If you buy a convertible bond, you’ll want to understand when and how the issuer can convert the bond and consider whether you are willing to own stock in the company instead of a bond.

How Does Investing in Bonds Differ from Other Investments

There are two other types of financial instruments that people consider buying as common alternatives to bonds – bond mutual funds and stocks.  I’ll briefly explain the differences between owning a bond and each of these alternatives.

Bond Funds

There are two significant differences between owning a bond fund and own a bond.

A Bond Fund with the Same Quality Bonds Has Less Default Risk

If you own a bond fund, you are usually buying an ownership share in a pool containing a relatively large number of bonds.  Owning more bonds increases your diversification (see this post for more on that topic).  With bonds, the biggest benefit from diversification is that it reduces the impact of a single issuer defaulting on its payments.  If you own one bond, the issuer defaults and the loss given default is 50%, you’ve lost 50% of your investment.  If you own 100 bonds and one of them defaults with a 50% loss given default, you lose 0.5% of your investment.

A Bond Fund Has Higher Market Risk than Owning a Bond to Maturity

Recall that you eliminate market risk if you hold a bond until it matures.  Almost all bond funds buy and sell bonds on a regular basis, so the value of the bond fund is always the market price of the bonds.  Because the market price of bonds can fluctuate, owners of bond funds are subject to market risk.

Stocks

When you buy stock in a company, you have an ownership interest in the company.  When you own a bond, you are a lender but have no ownership rights. To put these differences in perspective, owning a stock is like owning a share in vacation home along with other members of your extended family.  By comparison, owning a bond is like being the bank that holds the mortgage on that vacation home.

Stocks Have More Market Risk

The market risk for stocks is much greater than for bonds.  Ignoring defaults for the moment, the issuer has promised to re-pay you the par value of the bond plus the coupons, both of which are known and fixed amounts.  With a stock, you are essentially buying a share of the future profits, whose amounts are very uncertain.

Stocks Have More Default Risk

The default risk for stocks is also greater than for bonds.  When a company gets in financial difficulties, there is a fixed order in which people are paid what they are owed.  Employees and vendors get highest priority, so get paid first.  If there is money left over after paying all of the employees and vendors, then bondholders are re-paid.  After all bondholders have been re-paid, any remaining funds are distributed among stockholders.  Because stockholders take lower priority than bondholders, they are more likely to lose some or all of their investment if the company experiences severe financial difficulties or goes bankrupt.

Companies often issue bonds on a somewhat regular basis.  When a bond is issued, it is assigned a certain seniority.  This feature refers to the order in which the company will re-pay the bonds if it encounters financial difficulties.  If you decide to invest in bonds of individual companies, especially less-than-investment grades bonds, you’ll want to understand the seniority of the particular bond you are buying because it will affect the level of default risk.  Lower seniority bonds have lower credit ratings, so the credit rating will give you some insight regarding the seniority.

When is Investing in Bonds Right for Me

There isn’t a right or a wrong time to buy a bond, just as is the case with any other financial instrument.  The most important thing about buying a bond is making sure you understand exactly what you are buying, how it fits in your investment strategy and its risks.

Low-Risk Investment Portfolio

If you are interested in a low risk investment portfolio, US Government and high-quality corporate bonds might be a good investment for you.  As you think about this type of purchase, you’ll also want to think about the following considerations.

How Long until You Need the Money

If you are saving for a specific purchase, you could consider buying small positions in bonds of several different companies or US government bonds with maturities corresponding to when you need the money.  If you’ll need the money in less than a year or two, you might be better off buying a certificate of deposit or putting the money in a money market or high yield savings account.  If it is a long time until you’ll need the money and you think interest rates might go up, you’ll want to consider whether you can buy something with a maturity sooner than your target date without sacrificing too much yield so you can buy another bond in the future at a higher interest rate.

How Much Default Risk are You Willing to Take

If you aren’t willing to take any default risk, you’ll want to invest in US government bonds.  If you are willing to take a little default risk, you can buy high-quality (e.g., AAA or AA) corporate bonds.  You’ll want to buy small positions is a fairly large number of companies, though, to make sure you are diversified.

How Much Market Risk are You Willing to Take

If you are willing to take some market risk, you can more easily attain a diversified portfolio by investing in a bond mutual fund.  As mentioned above, you’ll want to consider whether you think interest rates will go up or down during your investment horizon.  If you think that are going to go up, there is a higher risk of market values going down than if you think they will be flat.  In this situation, a bond fund becomes somewhat riskier than buying bonds to hold them to maturity.  If you think interest rates are going to go down, there is more possible appreciation than if you think they will be flat.

High-Risk Investment Portfolio

If you want to make higher return and are willing to take more default risk, you can consider buying bonds of lower quality.  As shown in the chart above, non-investment grade bonds pay coupons at very high interest rates.  However, you need to recognize that you are taking on significantly more default risk. One approach for dabbling in high-yield bonds is to invest in a mutual fund that specializes in those securities. In that way, you are relying on the fund manager to decide which high-yield bonds have less default risk. You’ll also get much more diversification than you can get on your own unless you have a lot of time and money to invest in the bonds of a large number of companies.

Where Do I Buy Bonds and Bond Funds

You can buy individual bonds and bond mutual funds at any brokerage firm.  Many banks, particularly large ones, have brokerage divisions, so you can often buy bonds at a bank.  This article by Invested Wallet provides details on how to open an account at a brokerage firm.

All US Government bonds, including Savings Bonds and TIPS can be purchased at Treasury Direct, a service of the US Treasury department.  You’ll need to enter your or, if the bond is a gift, the recipient’s social security number and both you and, if applicable, the recipient need to have accounts with Treasury Direct.  US Savings Bonds can be bought only through Treasury Direct.  You can buy all other types of government bonds at any brokerage firm, as well.

As discussed in this post, it is best to buy bonds in a tax-advantaged account, such as an IRA, 401(k), Tax-Free Savings Account (TFSA) or Registered Retirement Savings Plan (RRSP) than a taxable account. You pay tax on the coupons every year when bonds are held in a taxable account, but you get the benefit of compounding without paying taxes along the way in a tax-advantaged account.

Investment Diversification Reduces Risk

Diversification-2

Investment diversification is an important tool that many investors used to reduce risk. Last week, I explained diversification and how it is related to correlation.   In this post, I’ll illustrate different ways you can use investment diversification and provide illustrations of its benefits.

Investment Diversification: Key Take-Aways

Here are some key take-aways about investment diversification.

  • Diversification reduces risk, but does not change the average return of a portfolio. The average return will always be the weighted average of the returns on the financial instruments in the portfolio, where the weights are the relative amounts of each instrument owned.
  • The smaller the correlation among financial instruments (all the way down to -100%), the greater the benefit of diversification. Check out last week’s post for more about this point.
  • Diversification can be accomplished by investing in more than one asset class, more than one company within an asset class or for long periods of time. One of the easiest ways to become diversified across companies is to purchase a mutual fund or exchange traded fund.  Funds that focus on one industry will be less diversified than funds that includes companies from more than one industry.
  • Diversification reduces risk, but doesn’t prevent losses. If all of the financial instruments in a portfolio go down in value, the total portfolio value will decrease.  Also, if one financial instrument loses a lot of value, the loss may more than offset any gains in other instruments in the portfolio.
  • A diversification strategy can be very risky if you purchase something without the necessary expertise to select it or without understanding all of the costs of ownership.

I’ll explain these points in more detail in the rest of the post.

Diversification and Returns

The purpose of diversification is to reduce riskIt has no impact on return.  The total return of any combination of financial instruments will always be the weighted average of the returns on the individual financial instruments, where the weights are the amounts of each instrument you own.  For example, if you own $3,000 of a financial instrument with a return of 5% and $7,000 of a different financial instrument with a return of 15%, your total return will be 12% (={$3,000 x 5% + $7,000 x 15%}/{$3,000+$7,000} = {$150 + $1,050}/$10,000 = $1,200/$10,000).  Similarly, two instruments that both return 10% will have a combined return of 10% regardless of how correlated they are, even -100% correlation.

Investment Diversification among Asset Classes

When investing, many people diversify their portfolios by investing in different asset classes. The most common of these approaches is to allocate part of their portfolio to stocks or equity mutual funds and part to bonds or bond mutual funds.

Correlation between Stocks and Bonds

Two very common asset classes for personal investment are bonds and stocks. Click here to learn more about bonds, including a comparison between stocks and bonds.

 

The Theory

The prices of stocks and bonds sometimes move in the same direction and sometimes move in opposite directions.  In good economies, companies make a lot of money and interest rates are often low.  When companies make money, their stock prices tend to increase.  When interest rates are low, bond prices are high.[1]  So, in good economies, we often see stock and bond prices move in the same direction.

However, from 1977 through 1981, bond prices went down while stocks went up.  At the time, the economy was coming out of a recession (which means stock prices started out low and then rose), but inflation increased. When inflation increases, interest rates tend to also increase and bond prices go down. [2]

Correlation of S&P 500 and Interest Rates

Over the past 40 years, interest rates have generally decreased (meaning bond prices went up) and stock markets increased in more years than not, as shown in the graph below.

The blue line shows the amount of money you would have each year if you invested $100 in the S&P 500 in 1980.  The green line shows the interest rate on the 10-year US treasury note, with the scale being on the right side of the graph.  Because bond prices go up when interest rates go down, we anticipate that there will be positive correlation between stock and bond prices over this period. If we looked at a longer time period, the correlation would still be positive, but not quite as high because, as mentioned above, there were periods when bond prices went down and stock prices increased.

Historical Correlation of Stocks and Bonds

I will use annual returns on the S&P 500 and the Fidelity Investment Grade Bond Fund to illustrate the correlation between stocks and bonds.  The graph below is a scatter plot of the annual returns on these two financial instruments from 1980 through 2018.  The returns on the bond fund are shown on the x axis; the returns on the S&P 500, the y axis.  Over this time period, the correlation between the returns on these two financial instruments is 43%.  This correlation is close to the +50% correlation illustrated in one of the scatter plots in last week’s post.  Not surprisingly, this graph looks somewhat similar to the +50% correlation graph in that post.

Stock and Bond Returns and Volatility

Recall that diversification is the reduction of risk, in this case, by owning both stocks and bonds.  The table below sets the baseline from which I will measure the diversification benefit.  It summarizes the average returns and standard deviations of the annual returns on the S&P 500 (a measure of stock returns) and a bond fund (an approximation of bond returns) from 1980 to 2018.  The bond fund has a lower return and less volatility, as shown by the lower average and standard deviation, than the S&P 500.

Bond Fund S&P 500
Average 0.6% 0.8%
Standard Deviation 1.6% 4.3%

 

Diversification Benefit from Stocks and Bonds

The graph below is a box & whisker plot showing the volatility of each of these financial instruments separately (the boxes on the far left and far right) and portfolios containing different combinations of them.  (See my post on risk for an explanation of how to read this chart.)

In this graph, the boxes represent the 25th to the 75th percentiles.  The whiskers correspond to the 5th to 95th percentiles.  As the portfolios have increasing amounts of stocks, the total return and volatility increase.

Diversification Benefit from Stocks and Bonds – A Different Perspective

These results can also be shown on a scatter plot, as shown in the graph below.  In this case, the x or horizontal axis shows the average return for each portfolio.  The y or vertical axis shows the percentage of the time that the return was negative. (See my post on making financial decisions for an explanation of optimal choices.)

There are three pairs of portfolios that have the same percentage of years with a negative return, but the one with more stocks in each pair has a higher return.  For example, about 24% of the time the portfolios with 30% and 50% invested in bonds had negative returns.  The 30% bond portfolio returned 8.9% on average, whereas the 50% bond portfolio returned 8.5% on average.   Therefore, the portfolio with 30% bonds is preferred over the one with 50% bonds using these metrics because it has the same probability of a negative return but a higher average return.

How to Pick your Mix Between Stocks and Bonds

The choice of mix between stocks and bonds depends on how much return you need to earn to meet your financial goals and how much volatility you are willing to tolerate.  A goal of maximizing return without regard to risk is consistent with one of the portfolios with no bonds or only a very small percentage of them.  At the other extreme, a portfolio with a high percentage (possibly as much as 100%) of bonds is consistent with a goal of minimizing the chance of losing money in any one year.  The options in the middle are consistent with objectives that combine attaining a higher return and reducing risk.

Other Asset Classes

There are many other asset classes that can be used for investment diversification.  Some people prefer tangible assets, such as gold, real estate, mineral rights (including oil and gas) or fine art, while others use a wider variety of financial instruments, such as options or futures.  When considering tangible assets, it is important to consider not only the possible appreciation in value but also the costs of owning them which can significantly reduce your total return.  Examples of costs of ownership include storage for gold and maintenance, insurance and property taxes for real estate.  All of the alternate investments I’ve mentioned, other than gold, also require expertise to increase the likelihood of getting appreciation from your investment.  Not everyone can identify the next Picasso!

Investment Diversification across Companies within an Asset Class

One of the most common applications of diversification is to invest in more than one company’s stock. It is even better if the companies are spread across different industries.  The greatest benefit from diversification is gained by investing in companies with low or negative correlation.  Common factors often drive the stock price changes for companies within a single industry, so they tend to show fairly high positive correlation.

Diversification across industries is so important that Jim Cramer has a segment on his show, Mad Money, called “Am I Diversified?”  In it, callers tell him the five companies in which they own the most stock and he tells them whether they are diversified based on the industries in which the companies fall.

To illustrate the benefits of diversification across companies, I have chosen five companies that are part of the Dow Jones Industrial Average (an index commonly used to measure stock market performance composed of 30 very large companies). These companies and their industries are:

American Express (AXP) Financial Services
Apple (AAPL) Technology
Boeing (BA) Industrial
Disney (DIS) Consumer Discretionary
Home Depot (HD) Consumer Staples

 

Correlation Between Companies

The graph below shows the correlations in the annual prices changes across these companies.

The highest correlations are between American Express and each of Boeing and Disney (both between 50% and 55%).  The lowest correlation is between Apple and Boeing (about 10%).

The graph below shows a box & whisker plot of the annual returns of these companies’ stocks.

All of the companies have about a 25% chance (the bottom of the box) of having a negative return in one year.  That is, if you owned any one of these stocks for one calendar year between 1983 and 2018, you had a 25% chance that you would have lost money on your investment.

Adding Companies Reduces Risk

The graph below shows a box & whisker chart showing how your volatility and risk would have been reduced if you had owned just Apple and then added equal amounts of the other stocks successively until, in the far-right box, you owned all five stocks.

The distance between the tops and bottoms of the whiskers get smaller as each stock is added to the mix. If you had owned equal amounts of all five stocks for any one calendar year in this time period, you would have lost money in 19% of the years instead of 25%.  The 25th percentile (bottom of the box) increases from between -5% and 0% for each stock individually to +14% if you owned all five stocks.  That is, 75% of the time, your return would have been greater than +14% if you had owned all 5 stocks.

As always, I remind you that past returns are not necessarily indicative of future returns. I used these five companies’ stocks for illustration and do not intend to imply that I recommend buying them (or not).

Investment Diversification Doesn’t Prevent Losses

The above illustration makes investing look great!  Wouldn’t it be nice if 75% of the time you could earn a return of at least 14% just by purchasing five stocks in different industries?  That result was lucky on my part.  I looked at the list of companies in the Dow Jones Industrial Average and picked the first five in alphabetical order that I thought were well known and in different industries.  It turns out that, over the time period from 1983 through 2018, all of those stocks did very well.  Their average annual returns ranged from 19% (Disney) to 40% (Apple).  The Dow Jones Industrial Average, by comparison, had an average return of 10%.  That means that most of the other stocks in the Average had a much lower return.

Being diversified won’t prevent losses, but it reduces them when one company experiences significant financial trouble or goes bankrupt.  Here’s a recent example.

Pacific Gas and Electric

Pacific Gas and Electric (PG&E) is a California utility that conservative investors have bought for many, many years.  I’ve added it to the box & whisker plot of the companies above in the graph below.

PG&E’s average return (10%) is lower than the other five stocks and about equal to the Dow Jones Industrial Average.  Its volatility is similar to Boeing and Disney as shown by the height of its box and spread of it whiskers being similar to those of the other two stocks.

However, on the day I am writing this post, PG&E declared bankruptcy.  PG&E has been accused of starting a number of large wildfires in California as the result of allegedly poor maintenance of its power lines and insufficient trimming of trees near them.  Here is a plot of its daily stock price over the past 12 months.

In the year ending January 26, 2019, PG&E’s stock price decreased by 72%.  From its high in early November 2018 to its low in January 2019, it dropped by 87%.

How to Reduce the Impact of Another PG&E

Although diversification can’t completely protect you from such large losses, it can reduce their impact especially if you are invested in companies in different industries.   If the only company in which you owned stock was PG&E, you would have lost 72% of your savings in one year.  If, on the other hand, you had owned an equal amount of a  second stock that performed the same as the Dow Jones Industrial Average over the same time period (-6%), you would have lost 39%.  The graph below shows how much you would have lost for different numbers of other companies in your portfolio.

This graph shows how quickly the adverse impact of one stock can be offset by including other companies in a portfolio.  In a portfolio of five stocks (PG&E and four others that performed the same as the Dow), the 72% loss is reduced to about a 20% loss.  With 20 stocks, the loss is reduced to 10% (not much worse than the -6% for the Dow Jones Industrial Average).

Investment Diversification Over Time

Another way to benefit from diversification is to own financial instruments for a long time. In all of the examples above, I illustrated the risk of holding financial instruments for one year at a time. Many financial instruments have ups and downs, but tend to generally follow an upward trend.  The volatility and risk of the average annual return of these instruments will decrease the longer they are held.

20-Year Illustration

For illustration of the diversification benefit of time, I have used returns on the S&P 500. The graph below shows the volatility of the average annual return on the S&P 500 for various time periods ranging from one to twenty years.

To create the “20 Years” box and whiskers in this graph, I started by identifying all 20-year periods starting from 1950 through the one starting in 1997.  I calculated the average annual return for each 20-year period.  I then determined the percentiles needed to create this graph.  The values for the shorter time periods were calculated in the same manner.

The average return over all years is about 8.8%.  Because we are using data from 1950 to 2018 for all of these calculations, the average doesn’t change.

The benefits of long-term investing are clear from this graph.  There were no 20-year periods that had a negative return, whereas the one-year return was negative 25% of the time.

More Complicated Example

My post about whether Chris should pay off his mortgage provides a bit more complicated application of the same concepts. In that case, Chris puts money into the account for five years and then withdraws it for either the next five years or the next 21 years. The longer he invests, the more likely he is to be better off investing instead of paying off his mortgage.

A Caution about Individual Stocks

As a reminder, it is important to remember that this concept applies well to financial measures such as mutual funds, exchange-traded funds and indexes.  It also applies to the financial instruments of many companies, but not all.  If a company starts a downward trend, especially if it is on the way to bankruptcy, it will show a negative return no matter how long you own it.  If you choose to own stocks of individual companies, you will want to monitor their underlying financial performance (a topic for a future post) and news about them to minimize the chance that you continue to own them through a permanent downward trend.


[1]The price of a bond is the present value of the future interest and principal payments using the interest rate on the date the calculation is performed.  That is, each payment is divided by (1+today’s interest rate)(time until payment is made). Because the denominator gets bigger as the interest rate goes up, the present value of each payment goes down.    I’ll talk more about this in a future post on bonds.

[2]An explanation of the link between inflation and interest rates is quite complicated.  I’ll write about it at some point in the future.  For now, I’ll just observe that they tend to increase at the same time.