About the author: Rick Lears is Founder and Chief Investment Officer at Lear Investment Management.
The idea of increasing or maintaining exposure to fixed income during times of heightened market anxiety seems like a logical way to manage risk. Recently, however, things have not developed in the way financial planners and their clients had hoped.
Those who had increased their exposure to bonds over the past two years jumped into fixed income just in time for one of the worst bond crises in recent history. The broad bond market, as measured by the Bloomberg Aggregate Bond Index, is down almost 13% this year through the end of September. This is after a negative return in 2021.
What went wrong? While the investment community may be attributing the troubles to another black swan event, this misperception was actually rooted in the market’s fundamental misunderstanding of risk.
Traditional financial planning instructs investors to maintain a static allocation to fixed income securities – regardless of market conditions – to manage “risk”. The financial services industry has spent a great deal of time, money, and energy discussing how more fixed income can reduce risk in your portfolio. But what is risk?
Risk is one of the most discussed topics in business. It is also one of the most misunderstood. The investment industry relies heavily on a statistical tool called standard deviation to assess risk. In technical terms, the standard deviation calculates the dispersion of a data set relative to its mean. In other words, the more different an investment strategy’s returns are relative to its average return, the riskier that strategy is considered to be. Low standard deviation strategies, where returns are close to their historical average, are considered more predictable and therefore less risky.
This view of risk encouraged investors to switch into bonds at a time of heightened market turmoil, as the standard deviation of the broad bond market has been about a fifth that of stocks over the past three years, meaning bonds are likely to lose less than stocks over the past three years declining year.
But relying on standard deviation to measure risk is flawed. It doesn’t measure risk so much as stability. The differences between the two are not usually noticed in a bull market, but they become apparent in bear markets. The standard deviation only measures stability relative to the recent past, not expected future performance.
To understand the shortcomings of this approach, look at the Bloomberg Aggregate Bond Index. At the start of this year, the three-year standard deviation for this broad-based bond benchmark was 3.4%, with an average annual return of 4.8%. This tells us that earlier this year there was a 68% chance that bonds would return up to 8.1% on the high end and 1.4% on the low end. There was a 99.7% chance that bonds would return up to 14.8% or lose up to 5.3%.
As it turned out, however, the broader bond market fell significantly more: the aggregate bond index fell 9.7% in mid-August, despite the standard deviation suggesting that the probability of losses of this magnitude is less than 0.5%.
What was missing here was the context. Market risk in 2022 was not about the variation in performance around its mean. It was about the specific economic and market factors that led to increasing fears in the market in the first place. In particular, there was talk of rising interest rates weighing on equities but threatening bond prices even more, and the return of inflation hurting bonds but benefiting commodities tied to industrial production. Understanding the impact of economic factors on an asset class is just as important as the amount by which past returns have moved around their average.
These considerations are particularly important in order to adapt your own strategy to the current circumstances. Some call this investment style ‘tactical’, but we believe that tactical adjustments need to go further and move beyond general allocation decisions and engage with individual positions based on the specific risks in the market.
Late last year wasn’t the time to double bonds. It was time to switch to fixed income securities. It was also an opportunity to increase exposure to commodities and determine which types of commodities make the most sense given economic and geopolitical concerns. For example, when Russia’s invasion of Ukraine added to supply chain issues, attention began to turn to natural gas.
The investment industry has long recommended a static approach to asset allocation, or a tactical approach that relies on ETFs to make general price corrections. This year has highlighted the inadequacy of these approaches.
Unfortunately, today the stakes are higher when risks are misinterpreted than ever before. While investors could earn a 6% return on US Treasuries in the 1990s, “risk-free” Treasuries today yield closer to 3.5%, allowing investors to accept more risk for the same return they deserve need the past. The challenge for investors now is to take on more risk – but in the right way.
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