In a week that has seen one of the world’s most recognised investors, Warren Buffet, state that equities are cheaper than bonds and he can’t imagine why anyone would hold bonds when they can own equities, I feel that it is necessary to reiterate the diversification benefits of owning bonds alongside other assets and the positive effect on a portfolio’s Sharpe Ratio.
Measuring the Benefits of Diversification
An investment’s Sharpe Ratio is a measure of the excess return per unit of risk taken and is simply calculated as the total return of an asset, less the risk-free (cash) return, divided by the standard deviation of those returns. In other words, how much extra return is an investor receiving for taking on an extra element of risk? Investments that can consistently produce an above average return with little variability tend to exhibit better Sharpe Ratios, and hence a better risk/return profile.
A central tenet of diversification is the proposition that by combining two assets with a correlation of less than one, an investor can improve the risk/return profile of their portfolio. In addition, the lower the correlation between the assets, the greater the benefits of diversification. Hence, this is particularly true when blending equities and bonds due to the generally low correlation between the asset classes.
Proving Bonds Can Be Good for your Heart
We conducted some research to illustrate that an equity portfolio’s risk/return profile can be improved by adding fixed income securities, even when equities are raging. Hence, we looked at the period from 2003 to 2007 and measured the performance of the UK equity market, UK fixed income markets and various combinations of the two asset classes. The table below gives a summary of our findings.
The return history analysed above takes the average of the 25 rolling three-year periods between 2003 and 2007. These figures illustrate that, even during a period of equity market strength, by holding a proportion of your portfolio in fixed income securities you can improve the risk/return profile. A portfolio invested fully in the equity market gave you 1.78% excess return (over cash return) per unit of risk, whilst a portfolio split into 70% equities and 30% bonds provided 1.82%.
Further investigation into the cumulative return over the full five-year period revealed that the stock/bond mix that would have produced the highest Sharpe Ratio was 56% equities and 44% bonds. This portfolio would have compensated the investor with 1.27% of excess return per unit of risk. “But that’s a smaller return than the pure-equity portfolio,” I hear you cry. Yes, but this benefit comes at a smaller cost. A portfolio investing 100% in UK equity would have produced an annualised return of 15.4% from January 2003 to December 2007, with a standard deviation of 9.73. In comparison, our optimal portfolio would have still given you a 10.4% annualised return, but with a standard deviation of only 5.52. In layman’s terms, this means that adding fixed income even in times of substantial equity strength allows you to sleep a little easier at night, safe in the knowledge that your returns may be slightly muted but your portfolio’s performance will be notably more stable as the level of risk you’re exposing yourself to is much less.
The chart below displays the Sharpe Ratios of the portfolios we analysed, in the range from 100% to 20% equities.
Equities and Bonds, Not Equities Vs Bonds
We have deliberately analysed a period of equity market strength, for which in retrospect investors would intuitively argue that a 100% holding in equities would appear the optimal choice. However, it is a blend of equities and bonds that produce the best risk/return profile. I believe we have demonstrated that if an investor is concerned with the level of risk they are taking to achieve excess returns over cash, then it is essential to include an element of fixed income, regardless of the period of assessment. Not only will fixed income holdings provide downside protection should equity markets tumble, but they will also improve the level of return achieved per unit of risk.
So Mr. Buffet, regardless of the economic environment, investment horizon or relative valuation of equity versus bonds, it is nearly always prudent to include an exposure to fixed income within your portfolio to get the highest return per unit of risk (or, in other words, to give your nerves a rest).
This article was originally published on Morningstar.co.uk on October 8, 2010.
Morningstar Consulting Europe
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