We all know it by heart: Past performance is no guarantee of future results. Yet we constantly examine past performance to gain a bit of insight into the future - at least in terms of how certain phenomena are related. Consider what insight a look at the past can provide about investing in bonds going forward.
Of course, the performance of bonds is related to movement in interest rates. We have detailed information about how interest rate movement and bond returns have related to each other since 1948. Over the past 65 years, interest rates had a general rise and then a decline. From 1948 through 1981, the federal discount rate increased - not every year but as a general trend. In 1948, the federal discount rate was 1.34%, and by 1981 it reached 13.42%.
During this time of rising interest rates, the average annualized return for U.S. bonds was 3.83%. In the Rise & Fall chart below, the year-to-year performance of U.S. bonds is represented by the vertical bars. The U.S. bond performance was measured using intermediate-term U.S. government bond returns from 1948 to 1975 and the Barclays Capital Aggregate Bond Index returns from 1976 to 2012.
RATES DROP, BONDS THRIVE
As the chart shows, the federal discount rate began its descent in 1982 - not falling every year, but generally declining over the long term. At the end of 2012, the rate was 0.75%. During those 31 years, the average annualized return of U.S. intermediate bonds was 8.82%. Clearly, as the federal discount rate descended steadily, the three decades provided a wonderful environment for bonds to perform well.
Notably, U.S. stocks (as measured by the S&P 500) showed essentially the same performance during both periods. From 1948 to 1981, when interest rates were rising, the S&P 500 had an annualized return of 11%. During the recent 31-year period of declining interest rates, the S&P 500 generated an 11.14% annualized return. So, while interest rate movement has a marked impact on bond returns, stocks have been largely immune - they tend to march to a variety of drummers.
Furthermore, cash (as represented by the three-month Treasury bill) also seemed relatively unaffected. Cash averaged 4.49% during the 34-year period of rising interest rates and 4.72% during the 31-year period of declining rates.
In light of this review of history, advisors might ask: Should we avoid bonds as an ingredient in a diversified portfolio? To understand why the question is framed that way, it is helpful to look at the impact of multiple asset classes on a portfolio.
As the chart Asset Allocation Over Time below shows, a portfolio holding only U.S. bonds (as represented by U.S. intermediate government bonds in 1948-1975 and the aggregate bond index in 1976-2012) would have been noticeably affected by interest rate movements.
During the 34-year period of rising interest rates, 1948-1981, an all-bond portfolio averaged 3.83% per year, whereas during the last 31 years it produced an average annualized return of 8.82%. The difference in return for an all-bond portfolio during these two distinct time frames was a staggering 499 basis points.
How about a two-asset portfolio? Let's assume the classic "balanced" design, with 60% allocated to stocks (as measured by the S&P 500) and 40% to bonds, in a portfolio that is rebalanced annually. The differential in performance in a two-asset portfolio across the two time periods is much less dramatic, even though the positive impact of bonds is clear in the more recent 31-year period. A performance difference of 499 basis points in an all-bond portfolio shrinks to a 204 basis points difference in a 60% stock/40% bond, two-asset portfolio (10.56% versus 8.52%).
A four-asset portfolio that allocated 40% to large U.S. stocks, 20% to small U.S. stocks, 30% to bonds and 10% to cash (with annual rebalancing) generated an annualized return of 9.52% during the 34-year period when interest rates were rising and a 9.99% annualized return during the last 31 years, when rates were falling. The performance differential across the two time frames now shrinks to a mere 47 basis points.
Clearly, as diversification increases within a portfolio, the impact of the performance of one asset class on the overall portfolio is significantly reduced (assuming the allocations are not skewed heavily toward only one asset). This is precisely why portfolios should be diversified - by doing so, we lower risk by preventing the bad performance of one particular asset class from sinking a portfolio's overall returns.
Let's now examine how the performance of bonds impacts a broadly diversified 12-asset portfolio, using an asset allocation plan I call the 7Twelve portfolio, consisting of 12 asset classes, which are equally weighted at 8.33% of the portfolio. Each asset class is rebalanced annually.
As shown below in the 3 Bond Scenarios table, during the 10-year period from Jan. 1, 2003, to Dec. 31, 2012, the annualized return of the 7Twelve portfolio was 9.79%. The performance of U.S. bonds in isolation during this 10-year period (using the Barclays Capital Aggregate Bond Index) was 5.16%.
I inserted the worst 10-year performance for U.S. bonds since 1948 and measured the impact within a broadly diversified 12-asset portfolio. The worst 10-year period for U.S. bonds between 1948 and 2012 was 1950-1959, when the 10-year annualized return was only 1.34%. Using this 10-year period in the bond category, the overall return of the 12-asset portfolio dropped to 9.44% from 9.79%, a decline of 35 basis points.
I inserted the returns of the best 10-year period for U.S. bonds, which happened to be 1982-1991. During that decade, U.S. bonds generated a 10-year annualized return of 14.09%. Those superior bond returns were beneficial for the portfolio, of course: The 10-year return of the 12-asset 7Twelve portfolio increased to 10.48%.
For a person who places all of her investments in one asset - whether bonds or stocks or real estate - timing is everything. As it pertains to bond performance, the difference between the worst-case 10-year period and best-case 10-year period for a 100% U.S. bond portfolio was nearly 1,300 basis points.
But for an investor who used bonds within a diversified portfolio (in this analysis, a 12-asset model), the differential between the worst- and best-case bond periods was 104 basis points, or $2,445 in ending account value.
An investor who avoids any asset class completely in a diversified portfolio is making a guess that it will underperform and that another asset class will outperform. Building prudent portfolios is not about guessing and timing, though; it's about broad diversification.
By design, a diversified investment portfolio is insulated - not completely, but largely - from the normal swings in performance among its various components. The underperformance of one or several of its ingredients will not sink the performance of the overall portfolio.
In fact, a strategically built, diversified portfolio will always include asset classes that have underperformed within a time frame. This is unavoidable. But it's the overall performance of the entire portfolio that matters.
We can't predict with accuracy the future returns of various asset classes, but based on the past it is clear that building diversified portfolios liberates us from needing to make such predictions.
Craig L. Israelsen, Ph.D., is a Financial Planning contributing writer in Springville, Utah, and an associate professor at Brigham Young University. He is the author of 7Twelve: A Diversified Investment Portfolio With a Plan.