There are good reasons for investors to reduce the riskiness of their portfolios using bonds. However, some commentators like to point out the surprising result that a portfolio mixing stocks and bonds can sometimes beat both the all-stock portfolio and the all-bond portfolio. A recent example is a post by The Reformed Broker titled ‘The Triumph of Diversification’. I ran an experiment that shows that this kind of reporting can set up investors for unrealistic expectations.
Common sense tells us that if you start your investing year with some stocks and some bonds and make no trades, your overall return will be somewhere between stock returns and bond returns. However, by a quirk of mathematics, if you rebalance to your target portfolio mix after each year, it is possible for your multi-year returns with a mixed portfolio to outperform both an all-stock portfolio and an all-bond portfolio. Somehow your portfolio can become better than the sum of its parts.
I decided to see how often this happens. I used data since 1970 on Canadian stocks and bonds provided by Libra Investments to check the 33 rolling ten-year periods since 1970 to see how a 70/30 mix of stocks and bonds would have compared to either all stocks or all bonds.
Out of the 33 ten-year periods, the 70/30 mix won out 4 times. In each case, average yearly stock and bond returns were within 1% of each other and the 70/30 mix won by less than 0.08%. So, while a mixed portfolio can beat both stocks and bonds, it happens infrequently and the edge tends to be very small.
None of this means that a mixed portfolio is bad. It’s just that you should be considering including bonds in your portfolio for the purpose of controlling risk rather than hoping to outperform an all-stock portfolio.