Rethinking Diversification: Fixed Income’s Role in Today’s Market

Why diversify when equity indexes return more than 10% on average? And why not go a step further, add leverage, and boost returns even more? For younger investors, especially those in their 20s, 30s, or even early 40s, I’m a firm believer in a portfolio heavily invested in equities. Time is on your side. Market corrections become opportunities, not threats, because you have time to bounce back.

But diversification becomes essential when stability and capital preservation take priority, such as in retirement or portfolios dedicated to a specific purpose. A 20% drop isn’t just a paper loss. It’s a potential disruption to your lifestyle, long term plans, or a cause you’re stewarding.

Warren Buffett has famously said that index funds make “the most sense practically all of the time” for retirement savings. I agree as a general rule, but there are pitfalls to passive index investing. It’s important to remember that the S&P 500 fell more than 55% during the 2008 to 2009 financial crisis. Investors who bought at the peak had to wait over seven years just to break even. For those in or near retirement, that kind of drawdown can be devastating, not just financially, but emotionally.

And that’s where true diversification really matters.

Bear in mind that not all diversification delivers when it matters most. On paper, holding a mix of funds and asset classes may look safe, but in a crisis, many of them tend to fall together. Some call it “diworsification.” That’s the risk when correlations aren’t what they seem.

Traditionally, investors looked to U.S. Treasuries for diversification. When stocks fell, bonds often rose as investors sought safety. But that relationship is not always reliable. In the early 1980s, under Fed Chair Paul Volcker’s aggressive policies to fight inflation, 30 year Treasury yields soared above 15%, marking the start of a bond bull market that lasted for decades. As inflation dropped and rates steadily declined, bond prices climbed. In 2022, however, both the S&P 500 and long term Treasuries suffered double digit losses. That experience reminds us that bonds do not always protect investors when stocks decline.

What, then, is the alternative?

The answer lies in broadening your view of fixed income. Fixed income isn’t just Treasuries. It includes a range of investment types: corporate bonds with investment grade ratings, high yield (junk) bonds, municipal bonds, convertibles, and floating rate loans, among others. Each comes with its own risk and return profile, but when used thoughtfully, they can generate income, add stability, and soften volatility. While fixed income doesn’t always rise when stocks fall, it often declines less, helping cushion the blow.

Because of this, fixed income proves especially useful in the following three scenarios.

(1) Investors sitting on large amounts of cash (in portfolios or bank accounts): If you’re holding significant cash, it’s worth considering fixed income investments that generate attractive income without taking on too much volatility. Floating rate loans, for example, can offer relatively high yields with less price volatility than stocks. Depending on their credit quality and structure, these investments may offer higher income than cash, although they also carry risks that cash does not. The goal is to put some of that money to work without taking on the same level of market risk as equities.

(2) The Retired, Near Retirement, or Risk Averse: If you can’t afford to lose capital or stomach volatility, fixed income can offer peace of mind. These assets typically fluctuate less than equities, provide more predictable income, and help preserve capital. Over the years, I’ve seen how thoughtful fixed income allocations can meaningfully reduce stress for clients.

(3) The 40% in a 60/40 Portfolio: Historically, the 40% fixed income allocation was filled with Treasuries. That approach no longer works as reliably as it once did. But a diversified mix of fixed income can still serve the same purpose, earning income while helping stabilize overall returns. Because different types of fixed income respond differently to economic conditions, combining them thoughtfully can help smooth out portfolio swings and make the ride less bumpy over time.

In short, fixed income plays a critical role in reducing portfolio volatility and generating income, particularly when market uncertainty is high. It’s not about abandoning equities. It’s about building a portfolio that lets you sleep better at night while still participating in long term growth.

If your portfolio still leans on outdated assumptions about fixed income, it may be time to take a closer look.