Introduction to Corporate Finance

PART 2: VAlUATION, RISK AND RETURN

finance in practice

COMBINING EQUITIES AND BONDS

In section 6-2, we looked at an investor’s decision to

invest in equities or bonds when saving for retirement.

As you might expect by now, there are likely to be

advantages for the investor to hold both equities and

bonds (that is, to diversify across asset classes) rather

than to hold just one of these investments.

The chart below uses data on the performance

of shares and bonds from 1970–2010 to

demonstrate the benefits of combining shares

and bonds in a portfolio. The upper boundary of

this type of chart is often referred to as an efficient

frontier. It helps investors to assess how they should

allocate their investments in order to maximise their

investment return or minimise their investment risk.

Remember that shares earn higher returns, but

those returns are also more volatile than are bond

returns. Does this imply that investors who place

a high value on safety should invest 100% of their

retirement savings in bonds?

The surprising answer is no. Even investors

wanting to follow a very conservative investment

strategy should probably hold at least some shares.

Notice that, starting from a portfolio invested entirely

in bonds, increasing the allocation devoted to shares

simultaneously increases the portfolio’s return and,

at least up to a point, lowers the portfolio’s standard

deviation. In other words, the standard deviation

of the portfolio is less than the standard deviations

of either of the two assets in which the portfolio

invests. How can this occur? The risk reduction

occurs because equity and bond returns do not

always move in the same direction, so sometimes

their movements offset or mitigate each other, just

as is the case with ADM and Coca-Cola. In fact, by

looking at the graph we can make a very strong

statement. As long as investors prefer higher returns

over lower returns, and less volatility rather than

more, investing exclusively in bonds doesn’t make

much sense. Notice that the diversified portfolio

containing an equal mix of equities and bonds has

about the same standard deviation as the bonds-

only portfolio, but with a significantly higher return.

efficient frontier
The upper boundary created
by charting the optimal
investment combinations
used to create portfolios that
maximise expected returns for
any level of expected risk, or
that minimises expected risk
for any level of expected return

8

10

12

14

Portfolio return (%)

Returns and standard deviations of portfolios of equities and bonds, 1970–2010

6 8 10 12 14 16 18 20

Portfolio standard deviation (%)

100% equities

50-50 split

100% bonds