13 Apr 2018 Rocky Road – Smoother Ride
On January 26th, markets abruptly exited the smooth freeway we had grown so accustomed to for a rocky cross-country romp that may continue for some time. The uncertainty of trade wars, Federal Reserve interest rate tightening, and possible inflation have replaced the confidence of tax cuts, a growing economy, and infrastructure spending. But this time, the bumps seem worse than usual. According to the pundits, the shock dampening effect of bonds, specifically US Treasurys, is no longer working. Our 7-10 year Treasurys are down 2.4% so far this year, while stocks, as measured by the US Total Market Index, are up 0.36%. So what’s going on?
Advisors and market oracles have encouraged investors to dump their bonds in favor of stocks for several years now. They have correctly argued that the returns on stocks will significantly surpass the returns on bonds, but they’ve missed the far more important point of why bonds belong in portfolios. Bond prices generally move in opposite directions of stock prices. When combined with stocks in a portfolio, bonds provide a stabilizing force that smooths the inherent volatility of stocks.
Think of stocks as a very bumpy road and think of bonds as the shock absorbers on that vehicle we call the portfolio. The importance of a smooth ride can’t be understated. We all understand efficiency. The more efficient a vehicle is, the longer it can travel. The same idea applied to wealth is described in efficient portfolio theory. Simply put, an efficient portfolio provides the most return for a specific level of risk, or in our vernacular; it is the smoothest ride (most efficient) across the most direct road to our destination, no matter how bumpy the terrain.
The figure below illustrates the huge differences in the volatility of stocks (blue line) vs. Treasurys (gold line). Since January 26th, stocks are down 6.35% while 7-10 yr Treasurys are down 0.71%. But that’s not the whole story. During that period, Treasurys (gold line) have have experienced average price swings of just under a quarter of a percent, while stocks have averaged 0.41% daily swings. Bonds have exceeded their average price swing 26 times in the last 54 trading days, while stocks have exceeded their average price swing 37 times. They’ve been up and down more than 2% six times.
Minimizing the impact of the bumps is important not only for emotional comfort, but vital for reducing the erosion of wealth when money is added to or taken from a portfolio. The more prices move when buys and sells are occurring, the more likely a large, or a series of smaller deposits or withdrawals, will occur at wrong times to erode wealth.
Look below to see how an efficient portfolio, comprised of 60% stocks and 40% bonds and cash, preserves wealth compared to the stock market alone. Notice how the green line (the 60/40) portfolio rides above the more jagged peaks and valleys of the blue stocks line. The Treasurys, while down a bit, have done their job of keeping the portfolio efficient by delivering maximum returns though a higher-than-usual period of risk.
But no matter how efficient your portfolio is, if it’s not on the right road, you’re on a joy ride to a place almost certainly less desirable than your ideal place. The only way to confidently reach your ideal destination is with a map, a map you design that determines the best roads, prepares you for a winding and sometimes bumpy journey, and allows you to check your progress along the way, making adjustments if needed.
We have opinions and ideas like everybody else in our industry about where the markets are going, but in all honesty, ours and theirs do not matter a whit. What matters is where you are relative to your destination and what adjustments need to be made to ensure you get there, even through the roughest of roads ahead. Please give us a call if you are not completely sure you are on the right road.