You don't buy bonds because you want that 2% yield. You buy them because they go up when stocks go down, and on average they grow faster than cash.
"go up when stocks go down" means "yields decrease when stocks go down"; therefore you are making a bet that rates will decline when stocks fall. you are assuming negative correlation of stocks and bonds.
A 75% stock 25% bond portfolio has higher average annual returns AND less historic downside than a 75% stock 25% cash portfolio.
Agreed, because generally cash (3 month T-bills) return less than the bond market and because historically the negative correlation between stocks and bonds that you assume will happen has happened.
Yes, historically bonds prices go up when stocks crash. There is a negative correlation and I assume it will continue to exist. Let's go back a step and ask "why" that negative correlation exists in the first place.
Stock and bond prices aren't negatively correlated during periods of high volatility because of chance, or magic, or because someone says so. They are negatively correlated because they compete for attention.
Go back to 2008. Hundreds of billions of dollars are being pulled from the stock market. Where does that money go? People aren't withdrawing the money to put under their mattress. In a big crash we experience a 'flight to quality' which could just as easily be named a 'flight to the safest bonds.' When people pull their money out of the stock market out of fear that money tends to go to one of three places.
1. money markets(backed by short term high quality commercial paper & t-bills[gov bonds]).
2. treasuries(gov bonds)
3. bank accounts. Well in a recession, especially like an '08 credit crisis, banks aren't going to lend to just anyone. They have hundreds of billions of dollars in new deposits, at the same time they aren't lending out more money. Are they going to pay you interest and then earn nothing themselves? Of course not. They are going to keep that money with the Fed(who buys gov bonds) or parked in safe quality investments... gov bonds.
YES, I believe that when stocks crash (safe)bonds go up. This is true whether bonds are yielding 10%, 5%, 2%, 0.01%, or even negative -1%. When the UK voted to leave the EU European stocks went down, and German bonds which already had negative yields saw their values increase(yields went down even more). Even with negative bond yields the negative correlation to stocks remained. When people are scared they will GLADLY pay for safety.
There are many paths the money can take, but in a crash money moves from risky investments(stocks) to the safest
investments (gov bonds). As long as that is true and as long as bonds earn more than cash then a stock & bond portfolio is more efficient than a stock & cash portfolio.
@mrspendy, as long as flight to quality exists I believe that bonds will rise in value when stocks crash. Do you see any reason flight to quality would cease to exist?
*Now, one scenario where both stocks and bonds do poorly, unexpected high inflation. If yields have to rise quickly to combat inflation that is bad for bonds, and if bonds start yielding 6% that is going to make them pretty attractive compared to stocks at high valuations which could put a damper on stock returns. I recognize this. However, it isn't a crash. Neither investment class is losing 50% of it's value because inflation came in higher than expected. Yes, holding money in cash to then deploy into bonds/stocks would yield better returns than holding stocks/bonds in the
short term, but that's market timing which is very unreliable.
Long term, even with higher inflation, the stock/bond portfolio would be better since the bonds will adjust to the higher yields giving you higher long term returns and stocks tend to be the best long term hedge against inflation. On that note, inflation has been historically low the past few years, and central banks are having a harder time fighting off deflation than inflation.
