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Why you need shares and bonds in your portfolio

May 15 2017 13:45
Schalk Louw

Schalk Louw, portfolio manager at PSG Wealth

When we do a correlation analysis on local shares’ (FTSE/JSE All Share Index) rolling 12-month returns versus that of local bonds (SA All Bond Index), we will see that since December 1999 until now, they have had an inverse correlation coefficient of -0.09. 

What exactly does this mean? A correlation coefficient measures the ratio between two variables and usually produces a value of between -1 and +1, which indicates the strength of the ratio between the two data points. A value of +1 means that both data points show the exact same movements, while a value of -1 shows that these two data points move in opposite directions.    

Let’s use the weather patterns as an example: when South Africa experiences warm weather in summer, we have a positive correlation with Australia, for example, mainly because we are both situated in the Southern hemisphere and our seasons tend to be relatively similar. Although we might not necessarily have a correlation coefficient of +1, it is well known that we still have a very strong positive correlation coefficient in terms of weather patterns. SA and Britain poses a whole different story. As we are situated in different hemispheres, it usually means that while it’s hot and sunny in Southern Africa, it’s most likely cold to freezing in Britain, which means that we have a negative (or inverse) correlation coefficient in terms of weather patterns. 

Back to the data analysis of local shares versus local bonds: with an inverse correlation coefficient of -0.09 between these two asset classes or investments, it means that they do not go hand in hand at all. By taking this statement further on a statistical level, it means that if investors are looking for a safe hideaway when they are in fear of a decline in local equity investments, it can usually be found in local bonds, and of course, vice versa. 

This phenomenon is clearly visible in Graph 1, which indicates that over the last 17 years, local shares have experienced a decline of 30% twice over a 12-month rolling period. In both cases, it was local bonds that made a strong impact and delivered the best returns. Of course, the opposite was just as obvious with bonds that underperformed strongly while local shares delivered their best returns.

To make things more interesting, let’s suggest that you managed a 50/50 portfolio that consisted only of one half local shares and local bonds to make up the other half. Aside from the fact that the stock market experienced a 30% decline twice over a 12-month rolling period during these 17 years, this 50/50 portfolio would never have produced negative returns over any given three-year rolling period. On the contrary, your worst three-year rolling returns would have yielded 13%.

 

The question is, however, what factors can affect this correlation to such an extent that shares and bonds may decline at the same time? Briefly, in my opinion, there could be five main possible reasons: 

  • Interest rates that rise suddenly and by significant percentage points;
  • Inflation that begins to rise beyond control;
  • If the South African Reserve Bank falls into the wrong hands and/or starts to make big mistakes;
  • If the Rand suddenly experiences a massive decline in value;
  • A civil or even a world war. 

The problem with these factors is that even though we are relatively safe in terms of them, the events that took place this last month definitely triggered quite a few warning signs. I steel feel, however, that although it may not be impossible, the probability remains small that shares and bonds will collapse at the same time. It’s always good to remain on the safe side, however, so be sure to keep your portfolio diversified – not just between shares and bonds, but over several different asset classes. 

NEXT ON FIN24X

Quiz #163: 15-22 May

2017-05-15 12:30

 
 
 
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