As long-term, evidence-based investors, we know that our portfolios should be diversified. And if we wrinkle our foreheads a little and think about it for a minute, we may even be able to list some of the important benefits of having a well-diversified portfolio:

• First and foremost, a diversified portfolio reduces risk by owning multiple, uncorrelated asset classes which lowers the overall volatility of your portfolio.
• Secondly, a diversified portfolio spares us from the folly of trying to time markets by keeping us invested in the major asset classes at all times.
• Finally, a diversified portfolio enhances the benefits of rebalancing, by allowing us to periodically sell from outperforming asset classes (at higher prices) and reinvest in underperforming asset classes (at lower prices) so as to both maintain an appropriate level of risk and take advantage of the natural mean-reversion in asset prices.

While this may provide a good summary of why diversified portfolios are important, it does little to explain how to achieve this effectively. Investors with portfolios largely dominated by publicly traded equities are frequently in search of other asset classes that would be good diversifiers.

They often consider commodities, precious metals, real estate, private equity or even hedge funds. While these other asset classes may certainly provide some diversification benefits, investors often overlook perhaps the simplest and most cost-effective way of achieving the diversification they seek – namely, by including high quality bonds (particularly US Treasury bonds).

Consider the following chart, courtesy of Vanguard:

The chart above shows the performance of various asset classes during only the worst 10% of monthly US stock market returns from 1988 through August 2015. Notice that during down markets for stocks, fixed income investments, and in particular high quality and US government bonds, performed relatively well, and posted a positive median return during these periods of market stress. In other words, an allocation to bonds would have acted as a “shock-absorber” for the portfolio as a whole during periods of poor equity returns.

While the other asset classes did not decline as much as US stocks during the periods highlighted above, they nonetheless failed to provide the same level of protection to an equity portfolio that the fixed income investments did. Investors looking to diversify their equity portfolios may be able to simplify the process by looking at high quality bonds as their first line of defense.

As an added bonus, US Treasury securities are among the most liquid and least expensive to manage asset classes available. The attractive combination of effectiveness, low costs and high liquidity makes quality fixed income investments a compelling choice for portfolio diversification.