Let’s say you knew nothing about investing, and someone presented you with the following choices. Over the past 36 years there are two asset classes, and their return statistics are :
1973-2008 Asset Class A
Sharpe 6% : 0.21
Asset Class B
Sharpe 6% : 0.30
Most investors would choose asset class B due to the similar returns as A, but with much less volatility and drawdown. Obviously, asset class A is stocks and B is bonds. The problem with this analysis is a big bias in the period chosen – one of largely declining interest rates and two big bear markets in stocks. If you take the results back further to 1900, the results are a little different. Here stocks handily outperform bonds, albeit with much more risk.
There are lots of observations to be made here (the cyclical nature of returns, the importance of the period chosen, path dependency, what works in the past doesn’t mean it will work in the future, etc.) but the main point I wanted to highlight here was just how much risk a 60/40 portfolio has (60% stocks, 40% bonds). An investor putting 40% of his portfolio in bonds would still have been subject to a nasty 60% decline in the value of his portfolio. This doubles the roughly 30% drawdown investors faced with a 60/40 portfolio in February. How many investors do you think have a 60/40 allocation and are willing to absorb a 30% loss, let alone a 60% loss? Timing helps on the risk management front, but that is largely due to decreasing the risk in the equity allocation.