The stock markets are in free fall, with many wondering how to reposition their portfolios. The problem is that when this sale accelerates a person’s ability to manage their losses, it begins to dissipate, which motivates them to act – which often leads them to do the wrong thing (sell) at the wrong time ( market trough). In behavioral finance, this reaction is called “loss aversion”.
Incorporating a risk management overlay into your portfolio design can help prevent this from happening. By focusing on managing short-term volatility, the drag of risk is minimized and the structure of returns improved, two imperative factors for achieving its long-term goals and objectives. In effect, they minimize frontal volatility and therefore help prevent loss aversion from becoming established and wreaking havoc on a portfolio.
There are a number of ways to do this through good old-style diversification, but one of the most effective strategies also happens to be one of the easiest to deploy – government bonds.
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There have been many declines recently against holding government bonds simply because of their already low yields, with many believing that they could not go lower. Therefore, when examining external portfolios, it is not uncommon for us to see certain equity and cash compounds with little or no fixed income.
The problem, however, is that during market corrections, liquidity remains stable while government bonds recover, which significantly improves short-term portfolio protection. This is clearly evident in today’s environment despite ultra low yields.
For example, since Friday, the S&P 500 is down about 9.25% this year. If you held a 30% cash position, it would reduce the loss to 6.5%. A 30% weighting in an equal mix of short / medium / long term US Treasuries, on the other hand, would have protected 60% from the decline, reducing the loss this year to just 3.7%.
Figures look even better in the past 12 months, with a portfolio composed entirely of equity securities gaining 6.2%, 70/30 cash earning 4.4% while a 70/30 bond portfolio posted a return huge 9.4%.
The return per unit of risk-benefit is also clearly evident in the long term. Since 2009, we calculate that a portfolio composed entirely of stocks gained 12.9% on an annual basis, a 70/30 cash position 9.5%, while a 70/30 bond portfolio gained 10.4%. Looking at the Sortino ratio, which measures the risk-adjusted return on an investment asset, the 70/30 bond portfolio was 1.97 or 19% higher than the 1.66 in the all equity portfolio and 70/30 species.
Given the recent evolution of bonds, for those who are underweight, it may already be too late, but that doesn’t mean that you can’t deploy other tactics such as rebalancing by overlapping some of excess cash on the market or staying firm until things stabilize.
For those who are all-in, don’t let risk aversion affect you and remember that on average, the S&P 500 undergoes corrections of five percent or more at least three times a year. The problem is that some years, like 2018, experienced five of these movements while others, like 2017, did not. As a result, the years in which they occur always have the impression of “this time is different”, whether due to the debt crisis of the PIGS, Brexit or the current coronavirus.
Overall, even though we may be wrong and it is certainly uncomfortable, we do not think that this unrest is on the scale of the 2008 crash. If it is certain that COVID-19 will have an economic impact importantly, central banks provide an orderly flow of capital and money into the markets.
Ultimately, things will stabilize and bond yields will rise again, and investors will be tempted to ignore the merits of holding bonds.
Maybe it’s worth noting this episode, as this type of fix will come back again and again, bonds will mitigate the damage.
Martin Pelletier, CFA, is a portfolio manager and OCIO at TriVest Wealth Counsel Ltd, a Calgary-based private and institutional investment firm specializing in discretionary risk management portfolios as well as audit and investment monitoring services.
The stock markets are in free fall, with many wondering how to reposition their portfolios. The problem is that when this sale accelerates a person’s ability to manage their losses, it begins to dissipate, which motivates them to act – which often leads them to do the wrong thing (sell) at the wrong time ( market trough). In behavioral finance, this reaction is called “loss aversion”.
Incorporating a risk management overlay into your portfolio design can help prevent this from happening. By focusing on managing short-term volatility, the drag of risk is minimized and the structure of returns improved, two imperative factors for achieving its long-term goals and objectives. In effect, they minimize frontal volatility and therefore help prevent loss aversion from becoming established and wreaking havoc on a portfolio.
There are a number of ways to do this through good old-style diversification, but one of the most effective strategies also happens to be one of the easiest to deploy – government bonds.
Related
There have been many declines recently against holding government bonds simply because of their already low yields, with many believing that they could not go lower. Therefore, when examining external portfolios, it is not uncommon for us to see certain equity and cash compounds with little or no fixed income.
The problem, however, is that during market corrections, liquidity remains stable while government bonds recover, which significantly improves short-term portfolio protection. This is clearly evident in today’s environment despite ultra low yields.
For example, since Friday, the S&P 500 is down about 9.25% this year. If you held a 30% cash position, it would reduce the loss to 6.5%. A 30% weighting in an equal mix of short / medium / long term US Treasuries, on the other hand, would have protected 60% from the decline, reducing the loss this year to just 3.7%.
Figures look even better in the past 12 months, with a portfolio composed entirely of equity securities gaining 6.2%, 70/30 cash earning 4.4% while a 70/30 bond portfolio posted a return huge 9.4%.
The return per unit of risk-benefit is also clearly evident in the long term. Since 2009, we calculate that a portfolio composed entirely of stocks gained 12.9% on an annual basis, a 70/30 cash position 9.5%, while a 70/30 bond portfolio gained 10.4%. Looking at the Sortino ratio, which measures the risk-adjusted return on an investment asset, the 70/30 bond portfolio was 1.97 or 19% higher than the 1.66 in the all equity portfolio and 70/30 species.
Given the recent evolution of bonds, for those who are underweight, it may already be too late, but that doesn’t mean that you can’t deploy other tactics such as rebalancing by overlapping some of excess cash on the market or staying firm until things stabilize.
For those who are all-in, don’t let risk aversion affect you and remember that on average, the S&P 500 undergoes corrections of five percent or more at least three times a year. The problem is that some years, like 2018, experienced five of these movements while others, like 2017, did not. As a result, the years in which they occur always have the impression of “this time is different”, whether due to the debt crisis of the PIGS, Brexit or the current coronavirus.
Overall, even though we may be wrong and it is certainly uncomfortable, we do not think that this unrest is on the scale of the 2008 crash. If it is certain that COVID-19 will have an economic impact importantly, central banks provide an orderly flow of capital and money into the markets.
Ultimately, things will stabilize and bond yields will rise again, and investors will be tempted to ignore the merits of holding bonds.
Maybe it’s worth noting this episode, as this type of fix will come back again and again, bonds will mitigate the damage.
Martin Pelletier, CFA, is a portfolio manager and OCIO at TriVest Wealth Counsel Ltd, a Calgary-based private and institutional investment firm specializing in discretionary risk management portfolios as well as audit and investment monitoring services.