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Of course, an increase in correlation was not the full extent of the impact. By moving from a 50 percent stock/50 percent bond portfolio to a portfolio equally weighted across eight different asset and subasset classes, the investor ended up with only 12.5 percent of the portfolio in U.S. bonds and 87.5 percent of the portfolio in riskier assets. And although those risky assets increased average returns without significantly increasing average portfolio volatility (particularly from 2000 through 2007), the risk bled through during the global financial crisis. So, while the 50/50 portfolio returned -26 percent with a worst month (October 2008) of -10.0 percent, the eight-asset portfolio returned -38.4 percent with a worst month (October 2008) of -17.6 percent. The result? Not only has the "diversified" portfolio underperformed the 50 percent stock/50 percent bond portfolio since 2008, but it has done so with significantly higher volatility, as shown in Figure 5b.
Because of such contagion risks, it is critical for investors to understand the potential value of an allocation to high-quality bonds. During the global financial crisis, even as risky assets largely declined in lock step, U.S. bonds as measured by the Barclays U.S. Aggregate Bond Index returned 7.0 percent.13 Similarly, in August 1998—a prior contagion event—U.S. bonds returned 1.6 percent, while other types of assets posted negative returns: U.S. stocks, -15.6 percent; high-yield bonds, -5.5 percent; REITs, -9.4 percent; international developed markets, -12.4 percent; international emerging markets, -28.9 percent; and commodities, -5.9 percent. Other than U.S. bonds, only international bonds (+2.5 percent) saw gains. As illustrated in Figure 1, the long-term diversification properties of bonds are significant. And as realized during periods of risk aversion and flight from risky assets, high-quality bonds, particularly Treasury bonds, prove to be a destination of choice. So although bonds may not provide the long-term expected returns of other asset and subasset classes that are now accessible, bonds have been one of the more reliable assets that we have investigated to mitigate losses in the worst of times.14 Figure 6 illustrates the role of bonds in a portfolio. Maintaining the original allocation to U.S. bonds and diversifying the allocation to U.S. stocks across the six alternative assets identified in Figures 3, 4 and 5 significantly reduced the average volatility of the portfolio leading up to 2008. The cost was slightly lower total return from 1988 through 2007. Since the global financial crisis, however, by maintaining the bond allocation, an investor would have been able to maintain his or her portfolio volatility levels, and even modestly boost returns. So for investors who maintained their exposure to bonds, diversification worked exactly as we would expect it to work, even accounting for increased correlations across risky assets coupled with significantly poor returns.
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