Diversification still works
At a glance:
- Diversification is key in maintaining a portfolio built for long-term success.
- Machine learning allows us to test core investment principles such as the fundamental role of bonds in a well-diversified portfolio.
Diversifying your portfolio is one of the most important things you can do to manage investment risk. Bonds are commonly used to help provide diversification and reduce risk against stock market dips. But with factors like market volatility and low interest rates that could rise, some may ask: Should bonds always play a role?
Diversification: The basics
It’s well known that implementing a diversified portfolio can be an essential way to manage risk. Having a balance of lower-risk assets (like bonds) and higher-risk assets (like stocks) allows your portfolio to grow while also providing a cushion against market volatility. Stocks typically provide higher returns than bonds over longer periods, but bonds can provide more stability when the market faces a downturn.
With interest rates at historic lows, investors may be wondering how bonds will perform when rates have seemingly nowhere to go but up. In this environment, why hold bonds at all? In addition to the wealth of existing evidence, our machine learning analysis helps provide the answer.
Machine learning: Why is it used?
Many industries use machine learning to analyze detailed historical data to gather critical insights and make more accurate predictions. We used an unsupervised technique called K-means clustering to test the relationship between stocks and U.S. government bonds during historically low-interest-rate periods. It allowed us to analyze the historical returns on stocks and government bonds to see what patterns exist between them.
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We observed that stocks and government bonds have a negative correlation (meaning they move in opposite directions), and there were very few instances in which stock and government bond values dropped simultaneously. Those results support the conventional wisdom that bonds have historically acted as a hedge against stock market drops during low-interest-rate periods. To put it simply: There’s no historical precedent that suggests investors should eliminate bonds from their portfolio.
Balance matters—and bonds play an important part. Maintaining a well-balanced, diversified portfolio remains one of the best ways to mitigate risk and invest for the long term.
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All investing is subject to risk, including possible loss of principal. Diversification does not ensure a profit or protect against a loss.
Investments in bonds are subject to interest rate, credit, and inflation risk.