Effect on Bond asset allocation if Equity markets crash?
what will happen to the valuation of Tom's bond holdings after the equity crash? This is primarily opinion based. What will happen is generally hard to predict. Bond Price Bump due to Demand:  Is a possible outcome; this depends on the assumption that the bonds in the said country are still deemed safe. Recent Greece example, this may not be true. So if the investors don't believe that Bonds are safe, the money may move into Real Estate, into Bullion [Gold etc], or to other markets. In such a scenario; the price may not bump up. Bond Price Decline due to Rising Interest Rates:  On a rising interest rates, the long-term bonds may loose in value while the short term bonds may hold their value. Related question How would bonds fare if interest rates rose? I agree that the cause of the crash can make a huge difference in the effect on the bond market. Here's a few other possibilities: All that to say that there's no definitive answer as to how the bond market will respond to an equity crash.  Bonds are much more highly correlated to equities lately, but that could be due to much lower interest rates pushing more of the risk of bonds to the credit worthiness of the issuer, increasing correlation.
It certainly creates an opportunity for the re-distribution of wealth.  Money will be transferred from insurance companies to construction companies.  Businesses that go under will be replaced by ones that survived. Some companies will make a profit out of this, but as you have already figured out, no new wealth is created by the disaster.  (Although lots has been destroyed, so we are looking at a net loss.) Summarized article: On Friday, the Dow Jones Industrial Average dropped almost 275 points and wiped out the last of the index's gains for the year.   Friday's massive selloff was triggered by a dismal US jobs report and data indicating a European and Chinese economic slowdown. Friday was the worst day of the year for the market.   Worried investors moved cash to the US Treasury bond market which also dragged the yield to a record low.   Some analysts believe the panic in the market may cause the Federal Reserve to plan for additional stimulus.   Federal Reserve Chairman Ben Bernanke is scheduled to speak next week.   *For more summarized news, subscribe to the [/r/SkimThat](http://www.reddit.com/r/SkimThat) subreddit* If you're referring to investment hedging, then you should diversify into things that would profit if expected event hit. For example alternative energy sources would benefit greatly from increased evidence of global warming, or the onset of peak oil. Preparing for calamities that would render the stock market inaccessible, the answer is quite different.  Simply own more of things that people would want than you need.  A list of possibilities would include: Precious metals are also a way to secure value outside the financial markets, but would not be readily sellable until the immediate calamity had passed. All this should be balanced on an honest evaluation of the risks, including the risk of nothing happening.  I've heard of people not saving for retirement because they don't expect the financial markets to be available then, but that's not a risk I'm willing to take. "To your first comment: yup. To your second comment, A = L + E. If E goes down, and L goes up, the net effect is 0. Then, if L goes down, and A goes up, the net effect is 0 and we are balanced once again. There is no ""rebalancing"" equity. You just have to make sure that, at the end of your journal entries, the accounting equation holds.  It's a very unintuitive concept to wrap your head around, but spend some time mapping out the flow of various journal entries. Once it clicks, you'll really understand the logic." This is Rob Bennett, the fellow who developed the Valuation-Informed Indexing strategy and the fellow who is discussed in the comment above. The facts stated in that comment are accurate -- I went to a zero stock allocation in the Summer of 1996 because of my belief in Robert Shiller's research showing that valuations affect long-term returns. The conclusion stated, that I have said that I do not myself follow the strategy, is of course silly. If I believe in it, why wouldn't I follow it? It's true that this is a long-term strategy. That's by design. I see that as a benefit, not a bad thing. It's certainly true that VII presumes that the Efficient Market Theory is invalid. If I thought that the market were efficient, I would endorse Buy-and-Hold. All of the conventional investing advice of recent decades follows logically from a belief in the Efficient Market Theory. The only problem I have with that advice is that Shiller's research discredits the Efficient Market Theory. There is no one stock allocation that everyone following a VII strategy should adopt any more than there is any one stock allocation that everyone following a Buy-and-Hold strategy should adopt. My personal circumstances have called for a zero stock allocation. But I generally recommend that the typical middle-class investor go with a 20 percent stock allocation even at times when stock prices are insanely high. You have to make adjustments for your personal financial circumstances. It is certainly fair to say that it is strange that stock prices have remained insanely high for so long. What people are missing is that we have never before had claims that Buy-and-Hold strategies are supported by academic research. Those claims caused the biggest bull market in history and it will take some time for the widespread belief in such claims to diminish. We are in the process of seeing that happen today.  The good news is that, once there is a consensus that Buy-and-Hold can never work, we will likely have the greatest period of economic growth in U.S. history. The power of academic research has been used to support Buy-and-Hold for decades now because of the widespread belief that the market is efficient. Turn that around and investors will possess a stronger belief in the need to practice long-term market timing than they have ever possessed before. In that sort of environment, both bull markets and bear markets become logical impossibilities. Emotional extremes in one direction beget emotional extremes in the other direction. The stock market has been more emotional in the past 16 years than it has ever been in any earlier time (this is evidenced by the wild P/E10 numbers that have applied for that entire time-period). Now that we are seeing the losses that follow from investing in highly emotional ways, we may see rational strategies becoming exceptionally popular for an exceptionally long period of time. I certainly hope so! The comment above that this will not work for individual stocks is correct. This works only for those investing in indexes. The academic research shows that there has never yet in 140 years of data been a time when Valuation-Informed Indexing has not provided far higher long-term returns at greatly diminished risk. But VII is not a strategy designed for stock pickers. There is no reason to believe that it would work for stock pickers. Thanks much for giving this new investing strategy some thought and consideration and for inviting comments that help investors to understand both points of view about it. Rob Asset prices are inversely related to interest rates. If you're valuing a business or a bond, if you use a lower interest rate you get a higher valuation.  Historic equity returns benefit from a falling interest rate environment which won't be repeated as interest rates can only go so low.  edit: typo "I can think of a few reasons for this. First, bonds are not as correlated with the stock market so having some in your portfolio will reduce volatility by a bit. This is nice because it makes you panic less about the value changes in your portfolio when the stock market is acting up, and I'm sure that fund managers would rather you make less money consistently then more money in a more volatile way.  Secondly, you never know when you might need that money, and since stock market crashes tend to be correlated with people losing their jobs, it would be really unfortunate to have to sell off stocks when they are under-priced due to market shenanigans. The bond portion of your portfolio would be more likely to be stable and easier to sell to help you get through a rough patch. I have some investment money I don't plan to touch for 20 years and I have the bond portion set to 5-10% since I might as well go for a ""high growth"" position, but if you're more conservative, and might make withdrawals, it's better to have more in bonds... I definitely will switch over more into bonds when I get ready to retire-- I'd rather have slow consistent payments for my retirement than lose a lot in an unexpected crash at a bad time!" I think everyone assumes various segments of the market/economy are going to cool off at some point. The question isn't if it'll happen, but when, and how suddenly. I don't think it'll be that big of a deal if we see market corrections across stocks or real estate if they happen over the course of months, and if anything it'll be a relief to many. The trouble will be if it happens suddenly and 'violently,' as it did in 2007, causing bankruptcies, massive job losses and lasting damage. That probably depends more on whether or not this was an artificial bubble (caused by Fed policies, likely), like what caused the Great Recession, or if it's a more normal market cycles. It depends.  Very generally when yields go up stocks go down and when yields go down stocks go up (as has been happening lately). If we look at the yield of the 10 year bond it reflects future expectations for interest rates.  If the rate today is very low but expectations are that the short term rates will go up that would be reflected in a higher yield simply because no one would buy the longer term bond if they could simply wait out and get a better return on shoter term investments.  If expectations are that the rate is going down you get what's called an inverted yield curve.  The inverted yield curve is usually a sign of economic trouble ahead.  Yields are also influenced by inflation expectations as @rhaskett is alluding in his answer. So.  If the stock market crashes because the economy is doing poorly and if interest rates are relatively high then people would expect the rates to go down and therefore bonds will go up! However, if there's rampant inflation and the rates are going up we can expect stocks and bonds to move in opposite directions.  Another interpretation of that is that one would expect stock prices to track inflation pretty well because company revenue is going to go up with inflation.  If we're just talking about a bump in the road correction in a healthy economy I wouldn't expect that to have much of an immediate effect though bonds might go down a little bit in the short term but possibly even more in the long term as interest rates eventually head higher.  Another scenario is a very low interest rate environment (as today) with a stock market crash and not a lot of room for yields to go further down. Both stocks and bonds are influenced by current interest rates, interest rate expectations, current inflation, inflation expectations and stock price expectation.  Add noise and stir. Your asset mix should reflect your own risk tolerance.  Whatever the ideal answer to your question, it requires you to have good timing, not once, but twice. Let me offer a personal example. In 2007, the S&P hit its short term peak at 1550 or so. As it tanked in the crisis, a coworker shared with me that he went to cash, on the way down, selling out at about 1100. At the bottom, 670 or so, I congratulated his brilliance (sarcasm here) and as it passed 1300 just 2 years later, again mentions how he must be thrilled he doubled his money. He admitted he was still in cash. Done with stocks. So he was worse off than had he held on to his pre-crash assets. For sake of disclosure, my own mix at the time was 100% stock. That's not a recommendation, just a reflection of how my wife and I were invested.  We retired early, and after the 2013 excellent year, moved to a mix closer to 75/25. At any time, a crisis hits, and we have 5-6 years spending money to let the market recover. If a Japanesque long term decline occurs, Social Security kicks in for us in 8 years.  If my intent wasn't 100% clear, I'm suggesting your long term investing should always reflect your own risk tolerance, not some short term gut feel that disaster is around the corner. &gt;  How is a loan an asset?   To use your example, our starting books are $100 in cash (asset), which corresponds to $100 in equity. We then loan out $20 with a future return of $25, so our books have changed to $80 cash, $25 in collectable loans (assets), $20 in loan liabilities, and $80 in equity + $5 in interest revenue.   &gt; I cannot be acting like I HAVE that 20$ can I?  Not really, and lending banks are regulated very tightly by having both required minimum capital adequacy ratios (basically how many loans you can have out for a given amount of equity) and annual stress testing by the Fed (CCAR).  &gt; Isn't that how the 08' crash happened? Is the risk of default accounted for?   No and yes. Lending banks weren't really responsible for the crash and it certainly wasn't because of over-lending. The problem was that the mortgage backed securities that banks were trading were (at the time) not properly valued to account for their risk, and the resulting insurance contracts (Credit Default Obligations, or CDOs) were improperly priced *and* leveraged. The CDOs were overly complicated, and made some strong statistical assumptions about the underlying assets (the MBSs and the individual mortgages within them) that lead to a systemic underestimation of risk (autocorrelation in default probabilities, esp.) Banks since then have dramatically increased the size of their risk management departments, and I think it's fairly unlikely we see another systemic mispricing like that for some time.  &gt; default risk is not transferred with the asset  I don't agree with this in the basic cases. If I sell you the rights to collect a loan that I wrote, then absent of any other contract you will bear the full risk of the borrower defaulting.  &gt;  how can it possibly be sold in such a way that the risk of default is detached  Credit default swaps and other forms of insurance contracts. I could sell you the loan as above, but then you could buy an insurance contract on the loan that pays out if the borrower defaults. In other words, either the loan stays alive and you collect interest as normal, or it defaults and you receive some payout from the insurance contract which limits your downside risk. Just about every large financial institution will have themselves hedged like this to some extent, though perhaps by other means.   Regarding your overall question about student loan defaults, I'm in the camp that believes they're an overstated direct* risk. It's currently not possible to default on a student loan, and if the law allowing student loan bankruptcy came in to effect, I think we'd see a large adjustment of interest rates on student loans (and probably consumer loans, etc. as well) to compensate for the increased risk of holding these loans.  *Direct risk referring to the risk to the loan holder. I think there is a risk that consumer spending becomes weighed down by the burden of large loans. However, I also don't think this would appear as a sudden market shock, and would likely manifest over an extended period of time.  Just my thoughts, I'm sure there are some people who'll disagree with me on this. I think your premise is slightly flawed. Every investment can add or reduce risk, depending on how it's used. If your ordering above is intended to represent the probability you will lose your principal, then it's roughly right, with caveats. If you buy a long-term government bond and interest rates increase while you're holding it, its value will decrease on the secondary markets. If you need/want to sell it before maturity, you may not recover your principal, and if you hold it, you will probably be subject to erosion of value due to inflation (inflation and interest rates are correlated). Over the short-term, the stock market can be very volatile, and you can suffer large paper losses. But over the long-term (decades), the stock market has beaten inflation. But this is true in aggregate, so, if you want to decrease equity risk, you need to invest in a very diversified portfolio (index mutual funds) and hold the portfolio for a long time. With a strategy like this, the stock market is not that risky over time. Derivatives, if used for their original purpose, can actually reduce volatility (and therefore risk) by reducing both the upside and downside of your other investments. For example, if you sell covered calls on your equity investments, you get an income stream as long as the underlying equities have a value that stays below the strike price. The cost to you is that you are forced to sell the equity at the strike price if its value increases above that. The person on the other side of that transaction loses the price of the call if the equity price doesn't go up, but gets a benefit if it does. In the commodity markets, Southwest Airlines used derivatives (options to buy at a fixed price in the future) on fuel to hedge against increases in fuel prices for years. This way, they added predictability to their cost structure and were able to beat the competition when fuel prices rose. Even had fuel prices dropped to zero, their exposure was limited to the pre-negotiated price of the fuel, which they'd already planned for. On the other hand, if you start doing things like selling uncovered calls, you expose yourself to potentially infinite losses, since there are no caps on how high the price of a stock can go. So it's not possible to say that derivatives as a class of investment are risky per se, because they can be used to reduce risk. I would take hedge funds, as a class, out of your list. You can't generally invest in those unless you have quite a lot of money, and they use strategies that vary widely, many of which are quite risky. I would say the real story is less about the implications of low vol but rather what has caused it. IMO that would be:  1) lots of money chasing a handful of investments    a) loose monetary policy    b) wealth effects from fantastic returns since the GR    c) consolidation in various sectors (health, energy, tech)  2) rise of low cost index funds (all inflow go into the large swathes of the market so volatility across stocks is dampened)   3) various externalities of expansionary Fed policy    a) resulting low bond yields lead to larger flows into equities     b) low cost of debt feeding buybacks     c) it has been sustained for so long it has had stabilizing effect i.e. predictability is good for markets and business decision making   These factors make for an interesting story because what happens when some component of this system begins to show cracks? What happens when this low vol feedback loop ceases? Nobody knows. But it will not continue ad infinitum. Not all doom and gloom but it won't be the market we are used to today. Most of the “recommendations” are just total market allocations.  Within domestic stocks, the performance rotates. Sometimes large cap outperform, sometimes small cap outperform. You can see the chart here (examine year by year):  https://www.google.com/finance?chdnp=1&chdd=1&chds=1&chdv=1&chvs=maximized&chdeh=0&chfdeh=0&chdet=1428692400000&chddm=99646&chls=IntervalBasedLine&cmpto=NYSEARCA:VO;NYSEARCA:VB&cmptdms=0;0&q=NYSEARCA:VV&ntsp=0&ei=_sIqVbHYB4HDrgGA-oGoDA Conventional wisdom is to buy the entire market. If large cap currently make up 80% of the market, you would allocate 80% of domestic stocks to large cap.  Same case with International Stocks (Developed). If Japan and UK make up the largest market internationally, then so be it.  Similar case with domestic bonds, it is usually total bond market allocation in the beginning.  Then there is the question of when you want to withdraw the money. If you are withdrawing in a couple years, you do not want to expose too much to currency risks, thus you would allocate less to international markets. If you are investing for retirement, you will get the total world market.  Then there is the question of risk tolerance. Bonds are somewhat negatively correlated with Stocks. When stock dips by 5% in a month, bonds might go up by 2%. Under normal circumstances they both go upward. Bond/Stock allocation ratio is by age I’m sure you knew that already.  Then there is the case of Modern portfolio theory. There will be slight adjustments to the ETF weights if it is found that adjusting them would give a smaller portfolio variance, while sacrificing small gains. You can try it yourself using Excel solver.  There is a strategy called Sector Rotation. Google it and you will find examples of overweighting the winners periodically. It is difficult to time the rotation, but Healthcare has somehow consistently outperformed. Nonetheless, those “recommendations” you mentioned are likely to be market allocations again.  The “Robo-advisors” list out every asset allocation in detail to make you feel overwhelmed and resort to using their service. In extreme cases, they can even break down the holdings to 2/3/4 digit Standard Industrial Classification codes, or break down the bond duration etc.  Some “Robo-advisors” would suggest you as many ETF as possible to increase trade commissions (if it isn’t commission free). For example, suggesting you to buy VB, VO, VV instead a VTI. Anti-Facebook circlejerk continues. Where were these articles before it went public ? It makes it seem like bad for common investors when in reality they couldn't even get in on the stock. It was the institutional funds and connected investors who bought the stock at 38. The common market actually was the one that didn't support the stock once it went public.   If anyone, it's the institutional funds that got screwed.