Fixed Income

As the long-term returns figures show, an all-equity portfolio has attractive growth potential, but significant uncertainty about the exact outcome. For this reason, we describe an all-equity portfolio as being aggressive. It is most suitable for investors who are willing and need to take substantial risk in the pursuit of reward.

Investors with shorter investment horizons, a high level of risk aversion or less need to take risk should maintain portfolios that are significantly less aggressive than the all-equity strategy. For these investors, some portion of the portfolio should remain in fixed-income instruments. Bonds provide income and help reduce the overall risk in a portfolio. However, because of the fixed nature of the income stream from a bond, there is comparatively little upside potential in a bond portfolio. Investors are sometimes surprised to learn that bond prices can rise and fall with changes in interest rates, but the main source of investment returns from bonds are the interest payments they make.

A portion of your portfolio’s assets will be invested in high-quality fixed-income investments. Fixed-income investments will help reduce the overall level of risk in your portfolio, because fixed-income investments tend to be less risky than equities, and because the fixed-income investments represent an additional diversification of your assets. Fixed-income instruments should be used to reduce the overall level of risk to your comfort level. It is important to note that over the long term, fixed-income investments will typically have returns approximate to inflation.

The fixed-income investments for the portfolio will be in either short- or intermediate-term bonds. Research by Eugene Fama at the University of Chicago and other respected academicians has shown that long-term bonds historically have had wide variances in their rates of total return without sufficiently compensating investors with higher expected returns.[1] In terms of variability of total return, long-term bonds look more like stocks than shorter-term fixed-income vehicles such as Treasury bills. Yet, over long time periods, their respective total returns have consistently lagged behind those of equities. A look at the following graph will help illustrate the higher standard deviations (volatility) and lower total returns of bonds with maturities beyond five years.[2]


Risk and Return Examined for Bonds



Our purpose in holding some fixed-income investments is to mitigate the risk (volatility) of your overall portfolio. Subject to a given level of risk, we believe a combination of equities and high-quality, short- to intermediate-term fixed-income instruments is the most effective way to achieve your objective of maximizing returns. Replacing the traditional long-term bond holding with a combination of equities and short- to intermediate-term fixed-income vehicles should maintain the portfolio’s expected rate of return while decreasing its volatility.

[1] For example, see Edward L. Martin, “Intermediate-Term Bonds,” AAII Journal, January 1991, pp. 13-16.

[2] Treasury instruments 1964-2005: DFA Returns program, Ibbotson & Assoc. Standard deviation annualized from quarterly data