This is the second installment of our series on asset allocation. The first article was on buy and hold SP500, where we learned that risks were relatively high (2 drawdowns > 45%) over the past 20 years to earn a compound annual growth rate of 6.46%. In this article, I will look at buy and hold of the Dow Jones Composite Bond Index. Bonds are our great diversifier, and when incorporated into an equity portfolio, it is our intention to reduce risk without sacrificing gains. In essence, the sum of the parts (stocks plus bonds) is better than either entity alone, but that will be the next article in this series. But first we must understand the limitations to a passive (i.e., buy and hold) strategy if we want to construct portfolios that are strategic, balanced and targeted.
From November, 1991 to March, 2011, buy and hold (passive) of the DJ Composite Bond Index had a compound annual growth rate of 5.35%. $100,000 becomes $275,434. Figure 1 shows the equity curve for buy and hold of the DJ Composite Bond Index. (Of note, I have chosen this particular starting date as my models start in this time frame; future articles in this series will be making this "apples to apples" comparison.)
Figure 1. Equity Curve/ buy and hold DJ Composite Bond Index
Drawdown is the peak-to-trough decline (in percentage terms) of an investment, and it is measured from the time a retrenchment begins to when a new high is reached. Drawdown is a measure of risk. The maximum draw down for buy and hold DJ Composite Bond Index is 14.72%. As of March, 2011, the longest draw down period was 216 weeks. The draw down curve is shown in figure 2.
Figure 2. Draw down/ buy and hold DJ Composite Bond Index
Buy and hold DJ Composite Bond Index earned a return slightly less than buy and hold SP500 (5.35% v. 6.46%). However, the risk of loss was considerably less with buy and hold DJ Composite Bond Index. The reward to risk ratio (or CAGR to drawdown ratio) was 0.36, which is 3x better than buy and hold SP500.
In the next installment of this series, we will combine buy and hold SP500 with buy and hold DJ Composite Bond Index into a single portfolio and review the reward to risk profile.