Why a diversification is a piece of cake

After almost four years of false alarms, the bond bears are finally able to act smug. Broad-based Canadian bond index funds have fallen in price about 4% or so in since the beginning of May. Meanwhile, real-return bonds have taken it on the chin: they’ve plummeted about 13% and are headed for their worst calendar year since first being issued by the federal government in 1992.

In times like these investors question the whole idea of including these asset classes in a balanced portfolio. So it’s time for a reminder about how diversification is supposed to work.

It’s helpful to think about a portfolio like a cake recipe. You probably wouldn’t eat flour, baking powder or raw eggs on their own, but when you mix them with sugar, butter, vanilla and other ingredients the results are delicious. A baker doesn’t view ingredients in isolation: she considers how each interacts with the others to produce the final result.

In the same way, it’s important not to view individual asset classes in isolation. Real-return bonds are a perfect example. It would be hard to make a compelling argument for holding nothing but RRBs: their yields are low, and with such long maturities they’re quite volatile. But in the context of a diversified portfolio—they get a 10% slice in the Complete Couch Potato—they play a couple of important roles. They provide a hedge against unexpectedly high inflation, and they have low correlation—even some negative correlation—with other asset classes.

Swing your partner round and round

Although real-return bonds are vulnerable to big price swings on their own, they can reduce the overall volatility of a portfolio, because they often zig when other asset classes zag. RRBs and Canadian equities, for example, have frequently moved in opposite directions since the beginning of 2010:

When equities had a rotten year in 2011, real-return bonds returned close to 18% and (along with real estate) helped the Complete Couch Potato earn positive returns that year. They also produced double-digit returns in 2009 and 2010. On the other hand, RRBs performed poorly in 2006 and 2007, while Canadian equities were in double digits.

It’s not a perfect balancing act: you can’t expect one asset to consistently go up when the other goes down. But the relationship is strong enough to justify keeping bonds—both traditional and RRBs—in a balanced portfolio even when they don’t look enticing on their own.

Make volatility work for you

Remember the importance of rebalancing your portfolio when the asset classes diverge dramatically. After their outstanding performance from 2009 to 2011, real-return bonds probably climbed well above their target allocation in your portfolio. If so, the appropriate thing to do was trim them back to size and use the proceeds to prop up whatever was below its target. This year, US equities have soared in price as much as RRBs have declined. So if your portfolio is out of whack again, it may be time for another round of rebalancing.

When you “harvest volatility” in this manner it quickly becomes clear why you’re holding multiple asset classes in your portfolio, and how they work in partnership with each other.

We’d all like to know which asset classes will be this year’s winners and which will give us ulcers. Unfortunately, the market gurus who make these calls are often spectacularly wrong. As the holder of a diversified portfolio that’s periodically rebalanced, you don’t need to guess. You simply hold all the asset classes all the time, and you systematically sell high and buy low. It’s like having your cake and eating it too.