by Archie M. Richards, Jr., CFP^®
December 1, 2003

Stocks add volatility and risk to a portfolio of bonds, right?

Not always. In moderate amounts, the addition of stocks to a bond portfolio cuts the risk.

I cite a study of hypothetical investments during the 41-year period from 1960 to 2001. The study took into account prominent indexes of stocks and bonds. The stock index was the Standard & Poor's 500 Index, comprised of America's 500 largest stocks. The bond index was the Lehman Brothers Long-Term Government Bond Index. Dividends and interest were assumed to be reinvested in the portfolios from which they came.

The study contained 11 hypothetical portfolios, ranging from 100 percent bonds to 100 percent stocks. The other nine portfolios held 10 percent stocks & 90 percent bonds, 20 percent stocks & 80 percent bonds, 30 percent stocks & 70 percent bonds, etc. The percentages were assumed to be fixed at the beginning and not rebalanced thereafter.

As the percentage of stocks increased from one portfolio to another, so did the average annual returns. With 100 percent bonds, the average annual return for the 41 years was 7.8 percent. With 100 percent stocks, the annual return was a lot higher - 12.2 percent. The returns increased steadily as the percentage of stocks rose.

The surprise pertains to the portfolio with the biggest loss during any single year.

With 100 percent bonds, the biggest loss during any of the 41 years was 9.2 percent. With just a little bit of stocks added (10 percent stocks & 90 percent bonds), the largest annual loss was considerably less - only 6.9 percent.

With a few more stocks (20 percent stocks & 80 percent bonds), the biggest annual loss in any single year was smaller still - 6 percent.

With 30 percent stocks and 70 percent bonds, the largest annual loss was just a hair higher: 6.1 percent.

As the percentage of stocks rose above 30 percent, the largest annual loss during any single year increased by 2-to-3 percent in each portfolio. With 100 percent stocks, the largest annual loss for the 41-year period was 26.5 percent.

Stocks are generally considered to be more volatile than bonds. But this study shows that the results are less volatile when the percentage of stocks is increased from zero to 20 percent. The largest annual loss during any one of the 41 years fell from 9.2 percent to 6 percent.

Why? Because stocks and bonds don't move up and down together. To some extent, the cycles offset one another. When bonds are falling, stocks might be rising, softening the blow.

In my column of 6/30/03 (see www.archierichards.com), I recommend 60 percent stocks and 40 percent high-income securities. In the study I cite above, 60 percent stocks and 40 percent bonds produced average annual returns of 10.5 percent, with the largest loss in any single year at 14.1 percent.

A potential loss of 14.1 percent in a single year may be too high for you. But my portfolio is diversified to nine funds, not just two. The 60 percent in stocks is broken up into half domestic and half foreign stocks. The 30 percent in domestics is divided into four funds (big growth & value, small growth & value). The 30 percent in foreign stocks is divided into three regions (Europe, the Far East, and Emerging Markets). The 40 percent income share is split half to real estate investment trusts and half to long-term bonds. My approach also calls for rebalancing every 13 months.

Every one of these measures reduces volatility and risk. I don't expect the maximum annual loss of my recommended portfolio to be as low as 6 percent. But I do expect it to be lower than 14.1 percent.

Even if the bear market has made you fearful of stocks, include them in your portfolio anyway. Place something like 25 percent of your portfolio into a broad selection of stocks, preferably with one or more mutual funds. The return will be higher. But the risk of loss will be less than that of a portfolio of all bonds.

Despite the inclusion of the stocks, you'll be able to sleep like a baby.