Given the stock market's recent volatility, investors are wondering if it's time to sell their stocks and move to somewhat safer corporate bonds. We are often reminded that bonds are the safer investment and they tend to move opposite of stocks and have a negative correlation. Before making a drastic decision to sell, let's take a closer look at correlation and other important factors that should go into your decision.
Stocks Vs. Bonds
Stock and Bond Correlation
Investors use bonds as a diversifier among stock investments, and to generate income. Diversification reduces risk and maximizes returns because you have invested in assets that react differently to market conditions. Traditionally, bonds have been presented as an investment that moves in the opposite direction of stocks. However, this does not paint the full picture and needs to be looked at in context. According to a Morningstar, Inc. research report, government bonds have a negative correlation to stocks but corporate bonds do not. (For related insight, read about corporate bonds and credit risk.)
This means that as stocks lose value, corporate bonds most likely will also lose value. The bonds will typically not go down as much as stocks, which have little downside protection, but the overall portfolio will still decrease. Because of this correlation, you may not be better off running to bonds. To make the final decision you should look at your goals and timeline for your investments.
Goals and Timeline
Investors with a longer time horizon will be better suited to stick with the right asset allocation than to try and time the market. For example, it is appropriate for an investor who is 25 (or even 10) years away from retiring, to take the extra risk and buy stocks at lower prices. The long-term growth of stocks is a better place for them to have their money. (For related insight, read about achieving optimal asset allocation.)
The closer you are to retirement the trickier this question becomes. If you need your investments to produce income, then it is important to decide if corporate bonds or dividend stocks are a better place for you to be. The current stock market is overpriced. Some of this is due to low interest rates. Investors in search of yield, therefore, have moved to stocks instead of bonds. Thus you have a situation where if you stay in stocks you could lose capital.
However, low interest rates cannot be sustained forever. When rates eventually rise, the face value of your bonds will decline. Where you will again lose capital.
With both areas subject to capital loss you must now look to yield and your ability to combat the capital loss. When you invest in stocks you do not actually lose the capital until you sell. If you have enough income from the dividends and other sources such as a pension, and you do not need to sell, you will regain your capital if/when the market comes back.
With bonds, this is trickier. If you own a single bond outright and hold it to maturity you will protect your capital as you get the face value back at maturity. If you are using a mutual fund or ETF for your bond investing you may or may not lose capital, it is up to the decisions the fund manager makes. It is out of your control.
When it comes to comparing yield, high-grade bonds with a five to 10-year time horizon are yielding very similar to stocks, ranging from 2.0% to 3.5%.
Because of the similarities between the two and not having as much control over the bonds, stocks seem like a good place to be right now. Remember to keep the focus on blue-chip dividend stocks such as United Parcel Service, Inc. (UPS), General Electric Co. (GE) and The Coca-Cola Co. (KO). Then when the market does go down, you have less to worry about than a high-flying new growth stock. (Read more about how dividends affect stock prices.)
The Bottom Line
Where you are invested should be influenced by your goals and timeline. The further you are from retirement, the less you need to worry about today's market, which makes it easier to stick to your asset allocation. The closer you are to retirement the more important it is to understand what you need from your money and then pick the right place for your investments. With today's market, those looking for income will do better in equities rather than bonds.