Weekly Market Update June 23, 2023
Dow Jones Industrial 33,728.62 -1.66%, S&P 500 4,348.47 -1.39%,
Nasdaq Composite 13,492.52 -1.44%, US Ten Year 3.737%, Crude Oil $69.28
One of the most long-standing models for investment portfolio construction is the 60/40 portfolio, where stocks, or equities, make up 60% of a portfolio’s assets, while bonds, or fixed income investments, comprise 40%. Why has this been the so-called school solution over all these years?
Courtesy, TD Ameritrade. Stocks in this example are represented by the Ibbotson® Large Company Stock Index and bonds by the 20-year U.S. government bond. Risk and return are based on annual data over the 1970–2019 period and are measured by standard deviation and arithmetic average, respectively. The data assumes reinvestment of all income and does not account for taxes or transaction costs.
The chart above is an “efficient frontier.” Developed by Harry Markowitz in 1952, it is the foundation of Modern Portfolio Theory. Itshows the optimal portfolio offering the highest expected return for a defined level of risk, or conversely the lowest risk for a given level of expected return. Note that the very lowest level of risk, just under 10% standard deviation of return, is a portfolio that is 33%, or one-third, stocks. But are not bonds safer than stocks? In isolation, they are, because they offer a fixed rate of return and mature at face value (barring default). But even investment grade bonds are subject to market risk, or interest rate risk. Bond values move in the opposite direction of interest rates. When interest rates increase, prices of existing bonds fall to reflect the new, higher rates of interest. The total return of a bond for a given time may be negative, where the interest payments are less than the drop in value of the bond itself. The opposite happens when interest rates fall. Bond values may increase dramatically. The longer the time to maturity, the larger the changes in price.
Stock prices often move opposite to bond prices, and that is the basis for the efficient frontier. The two asset classes have less than perfect correlation, meaning they do not always move in the same direction, or to the same extent when they do. Below are the changes in the price of the intermediate treasury bond index as indicated by the iShares 7-10 Year Treasury bond ETF (orange) and the Standard & Poor’s 500 stock index, as represented by the SPDR S&P 500 ETF (blue). While the chart does illustrate the higher returns of stocks versus bonds over time, note how bonds outperformed stocks during the two-year financial crisis of 2007 through 2009. A commitment to bonds would have surely eased the pain from the sharp stock sell-off early in the crisis.
Chart Seeking Alpha.com
What one might take away from this discussion is to determine your tolerance for risk and adjust your mix of stocks and bonds accordingly. Our professionals at M&R Capital Management will be pleased to help you evaluate the risk in your current portfolio, and if desired offer a program to modify it to better align it with your preferred level of risk.
Wishing You a Profitable Week,