Around The World in 100 Words - January 2017, Week 4

Published by on

One month down, 11 to go. But it was a good start to the year –far better than 2016 which saw equity markets sell off sharply. President Trump has certainly made his appearance and world leaders and world markets are nervously wondering what’s coming next. Underneath this worry is risk. Risk is something that is always with us, always there, but disappears from our field of sight when our focus is elsewhere. So this weeks Around The World (ATW) is about risk. Risk means downside, and portfolio allocation is the determining factor as to how much downside a portfolio has.

Historically, stock markets (equities) have delivered the highest returns over time, though with the highest volatility. This has meant that there have been years where stocks have declined by significant percentages. In both time periods March 2000-March 2003 and March 2007-March 2009 saw equity markets decline by half. A 50% loss in stock markets. Wow. By contrast, Bonds fared well during these time periods, posting modest gains. So bonds serve to protect portfolios during periods of market downside.

The challenge is that bonds don’t pay like they used to. So investors have to increase their risk dramatically to achieve the same rate of return. The attached diagram shows that to earn a 7.5% rate of return, investors have to reduce their bond positions to just 12% of their portfolio. But by doing so, their risk increases by almost 300%. The question to be asked here is whether investors could or should accept massively higher risk in the hopes of achieving this level of return? Or should return expectations be reduced by lowering the risk level in the portfolio?

Our approach over 25 years has always been about protecting our client’s from market losses by constructing lower risk portfolios and setting reasonable return expectations of clients. In other words, defining risk first, and then setting reasonable target return expectations second. Doing it the other way around is putting the cart before the horse. As said so many times before, a well-diversified, well-managed portfolio comprised of bond and equity funds tailored to each client’s specific risk-return objectives is the best way to preserve and build wealth over time. In that order. Winning by not losing means our portfolios remain committed to their lower-yielding bond fund positions. But lower-yielding means lower losses. And with stock markets trading at record highs, the likelihood of a serious market correction is high. When it happens, bond funds are going to look great.