December 13th 2023.
Figuring out how much bonds dampen investment risk can be tricky. People often offer bromides like "bonds provide ballast" or "bonds smooth returns," but these truisms don't really help us think objectively.
One approach to consider is to plot investment outcomes in a line chart that compares a portfolio that holds 100% stocks to a portfolio that holds a balance of stocks and bonds, for example 70% stocks and 30% bonds. This way, it is easier to visualize if and how much difference bonds make.
To do this, we can use average stock market returns and volatility to run a Monte Carlo simulation that plots likely scenarios. A single 100% stocks portfolio can be run in comparison to 100 70% stocks and 30% bonds portfolios. By comparing these outcomes, we can see how bonds affect the results.
The chart logarithmically scales the value axis for legibility, so it is important to pay close attention to the scaling so the chart doesn't mislead. Bonds dodge some downside, but probably give up some upside.
The green, red and charcoal spreadsheet fragments also show the benefits of adding bonds. The higher risk Red Portfolio delivers a significantly higher average return, nearly one percent a year. This means that an investor on average ends up with about $500,000 more money at the end of the four decades.
To use the free spreadsheet and run your own Monte Carlo simulation, download the spreadsheet, and then enter the starting balance into cell B4 and specify any additional annual amounts saved using cell B5. By doing this, you can explore how bonds dampen investment risk for your own specific situation.
Figuring out how much bonds dampen investment risk can be tricky to understand. To get an objective understanding of the effect of bonds on investment risk, you can plot investment outcomes in a line chart that compares a portfolio that holds 100% stocks to a portfolio that holds a balance of stocks and bonds. For example, you can compare a portfolio that holds 70% stocks and 30% bonds.
One way of doing this is to use Monte Carlo simulations. A Monte Carlo simulation is a numerical method that uses average stock market returns and volatility to simulate investment outcomes. This method is used because we don't have enough data to plot hundreds or thousands of outcomes comparing 100% stocks to a 70/30 portfolio.
To visualize the effect of bonds on risk, a chart can be created that plots two simulations, a 100% stocks portfolio (shown as red lines) and a 70/30 portfolio (shown as two dashed black lines). The chart shows that the addition of bonds avoids the worst-case investment outcomes of the 100% stocks portfolio and also gives up some upside.
To understand the effect of bonds on investment risk in numerical terms, you can look at the green, red and charcoal spreadsheet fragments. The green cells show the input values such as the starting balance, annual addition, growth in additions and the two portfolio's returns and standard deviations. The red and charcoal cells summarize the Red and Black Portfolio simulation results.
You can experiment with the free Monte Carlo simulations spreadsheet to see the effect of bonds on investment risk. To use the spreadsheet, you will need to enter the starting balance into cell B4 and specify any additional annual amounts saved using cell B5.
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