Over the last week or so, we’ve seen several bouts of extreme volatility in stocks and bonds. In addition to creating nervous investors, volatility shows the power of a diversified portfolio in helping to mitigate risk and increase the potential for good returns. Nowhere is that dynamic more evident than in the total returns between the S&P 500 and Treasury bonds (the safest holding in the world at the moment).
At points throughout this year, stocks and bonds have rallied together, but they have taken starkly diverging paths in recent weeks. If we look at the trailing three-week rate of change in total returns of the two assets, then we can see just how much the start of August led investors to flee stocks in favor of bonds.
The chart above also illustrates how a diversified portfolio creates opportunity during times of volatility. The divergence of the two returns visually illustrates a textbook rebalancing opportunity, where you’d want to sell Treasuries (U.S. government bonds) and buy stocks.
The factors that ruin opportunities are mostly emotional. Stock declines are typically met with fear and can lead to regret and sometimes panic about our financial futures. Instead of selling Treasuries, the human heart longs to buy more. However, smart investors with diversified portfolios know that volatility in a market decline brings opportunity for better returns. So we buy more stocks.
Keep in mind that these two charts depict only several weeks of trading. Proper portfolio management takes into account much longer-term trends and time horizons that are appropriate to each household.
Over longer terms, these trends become more evident, and rebalancing (selling high and buying low) can be done methodically and unemotionally. Keeping emotions out of the mix is much more difficult than it appears, as we’re emotional beings, but to have successful investing outcomes, it’s best to resist!
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