Let us consider, for a moment, some facts. 1). There are many different asset classes such as property, bonds, commodities and equities. 2). Some of these asset classes are liquid and some are illiquid. 3). Nobody can, for certain, predict the movements of financial markets despite the fact that markets have historically risen over time.
These points are important, because it is safe to assume that sometime in your life, the financial markets will be down 10%, and quite possible, as much as 50%. This does not need to trouble long-term investors who can ride out the volatility, and is especially good for those that have cash lying around.
However, sensible asset allocation not only reduces your risk, but it also gives you a chance to benefit from the downsides as well. Let’s give an example of government bonds. Government bonds produced by the US Government and other developed and mature economies are one of the least volatile asset classes.
They usually barely outperform inflation, because investors do not demand much of a risk premium on such a safe asset. It is true, therefore, that bonds over the long-term do not yield as much as financial markets. Whereas the S&P and Dow Jones has historically yielded around 6.6% after inflation, which compounded has made them the best performing asset class, government bonds have yielded barely above inflation.
So why should investors consider bonds? Well for one, having some bonds in your portfolio cushions the blow of any market falls, as bonds usually go up during financial crashes, as they are seen as a safe heaven. Just as importantly, bonds allow you to buy equities cheaply during the crash.
Consider the following portfolio. The value is worth $100,000. 75%, or 75,000, is in international equity markets, and 25%, or 25,000, is in government bonds. Now imagine there is a market crash. The equities go down by 20% to $60,000 and the bonds have risen to $26,500 in the wake of the crash.
Now the portfolio is worth $86,500 and the bonds are worth $26,500 of that, meaning that the bonds are now worth more than 30% of the portfolio. This is important, because investors can now sell 5% of the bonds and buy equities at discounted prices, or even buy another 5-10% if markets fall further. Using this strategy, even if the market only recover back to there previous level, the investor will have more than the original $100,000, because he or she bought at discounted prices when the market fell.
Of course, investors can only make such a trade if their investments are liquid and there are no hefty exit charges for leaving funds. Nobody can sell physical art, property land or many commodities in a day or probably a week, and selling a fund which has a 5% exit charge does not make sense. This illustrates the importance of having a relatively liquid portfolio, where assets can be moved freely, quickly and cheaply from one asset class to another. It means that rational, medium and long-term investors, can actually look forward to buying at lower prices, which will help returns.