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Diversification Works


Last year was a tremendous year for US equities as they posted their best annual performance in nearly 20 years, up over 33%.  International stocks, while falling well short of US equities, still posted strong absolute performance.  The 15.6% foreign stocks rose was well above the average annual return.  Economists were calling for a return to higher growth levels and analysts were predicting another strong year from equities in 2014.  On the other hand fixed income had its first negative year since 1999, falling -2.0%.  The financial press and even the well respected bond manager Bill Gross said it was the end of the bond bull market.  Investors could pick up the Wall Street Journal weekly and see stories of how interest rates were surely going to rise and that owning fixed income is risky.

With such strong support to owning stock and little for owning fixed income it makes it tough for investors to remain comfortable with maintaining a fixed income allocation in their portfolios.  However, January showed why it’s important for an investor to remain diversified and provided clear reasoning for fixed income to be a component of an investor’s portfolio.  As concerns over global growth grew, investors sold out of equity positions and purchased bonds as they sought a safe haven.  US stocks and international stocks both sank over 3.1%, while bonds gained 1.5% for the month.  Bonds and particularly high quality bonds are considered much safer than equities and as a result will almost always be a refuge for investors in times of worry. 

Bonds and stocks have a negative correlation, meaning one typically rises when the other falls.  While this is not always the case, and they certainly both can rise or fall at the same time, owning fixed income helps provide a cushion for your portfolio when trouble hits the equity markets.  No one knows the future and it certainly is possible for interest rates to rise and for bonds to lose value temporarily, but the capital preservation that fixed income provides is a valuable asset in keeping a portfolio from seeing large swings in value.

In addition, the volatility level seen for fixed income is significantly lower than that of equity.  The standard deviation of US stocks, a measure of an investment’s volatility, is over four times greater than that of bonds.  A terrible year for the broad fixed income market is a -6% return, while a very bad year for stocks can be a -30% return.  One clearly is more risky than the other.

Each investor’s situation is unique and for some holding fixed income is unnecessary given their investment objectives and or time horizon.  However, for the majority of investors it is important to remain diversified with an allocation to fixed income to keep them on the right path towards achieving their investment goals.

Index Performance                                        Jan.      Trl 1 yr.        

US Stock (Russell 3000)                                    -3.16%      22.60%    
Foreign Stock (FTSE AW ex US)                      -4.51%        6.07%   
Total US Bond Mkt. (BarCap Aggregate)          1.48%        0.12%    
Short US Gov. Bonds (BarCap Gov 1-5 Yr)      0.39%       0.40% 
Municipal Bonds (BarCap 1-10yr Muni)            1.17%       0.62%   
Cash (ML 3Month T-Bill)                                   0.01%       0.08%