When Stocks Identify as Bonds

♫ It’s a mixed up, muddled up, shook up world ♫ – Ray Davies, The Kinks

Overall, 2022 was one of the worst years for investors.  Bonds had stock sized losses and so did the S&P 500.  Fortunately, some stock indices identified as bonds, suggesting a way to improve return reliability.

Normally, 5-year Treasury Bonds (aka intermediate-term government bonds, or ITGBs) act as a portfolio’s ballast, with neither large gains nor large losses.  According to Dimensional Fund Advisors (DFA), out of the last 95 years ITGVs have had only 12 years of losses, so losing money is unusual for these stalwarts.  Of those 12 losses, the average loss was about 2.5%.

Not only did ITGBs lose money, but 2022 was the worst calendar year in DFA’s records.  And it wasn’t even close.  These bonds lost a total of 9.4% over the year.  The previous largest loss was 5.1%.

This loss was stock sized, too.  The median of annual losses for the S&P 500 is 9.4% – almost exactly what those stodgy ITGBs lost.  Bonds were about as stocky as stocks get.

Not to be outdone, the S&P 500 lost over 18%, its 7^th worst year.  This combination had a one-two punch to the common benchmark stock and bond blend of 60% stock, 40% ITGB.  This blend lost 14.6%, its 4^th worst year.

On the other hand, another stock index, the DFA Small-Cap Value (SCV) index, is normally the wild and woolly index and is more volatile that the S&P 500.  In a down year, one might expect larger losses than the S&P 500.  But, while SCV didn’t exactly have a stellar year, its losses in 2022 were far less than ITGB’s and the S&P 500’s.  It lost 4.9%, which is far better than ITGBs and the S&P 500.  It was more bondy than bonds.

And here is the key.  During the past 95 years, ITGBs have had a lower correlation with SCV than with the S&P 500.  In other words, when bonds lose money, SCV is more likely to counterbalance those losses than the S&P 500.  And vice versa.  When SCV loses money, bonds are more likely to be a counterbalance to those losses.

The differences are not huge, and this doesn’t always play out.  Over the long-term, however, these subtle differences can be utilized to improve the stability of your portfolio.

Consider a 31% SCV, 69% ITGV portfolio, or the “small-cap blend”.  Despite about half as much in stocks, it has demonstrated slightly better returns over the 95-year period compared to the standard 60/40 blend.  In addition, its volatility has been substantially lower.  The worst one-year loss was 19% versus 27% for the standard blend.  The small-cap blend had 18 calendar years of losses while the standard had 22, a reduction in the number of annual losses by about 18%.  And in 2022 the small-cap blend lost 8% compared with 14.6% for the standard blend.

It’s important not to draw any conclusion from 2022 by itself.  There are many counter examples.  Nevertheless, 2022 demonstrates what one would hope to achieve with informed portfolio selection.  By utilizing the properly diversified portfolio that includes indexes such as small-cap value, you may achieve more reliable returns without sacrificing long-term returns.

As always, historical returns are no guarantee of future returns and your mileage may vary.