As I write this today, many of my clients who consider themselves to be conservative, long-term investors are holding positions in what most people would characterize as risky investments. Securities that represent commodities like coffee and natural gas. Foreign stock markets like Greece and Spain. Junk bonds. Foreign junk bonds. You get the picture.
These investments have been made on my advice. As someone charged with the responsibility of ensuring that the investments I make or recommend be suitable for that person, these are not decisions that have been made lightly. In fact, these investments are made precisely because of that responsibility.
Conventional wisdom says that a conservative long-term investor that is primarily interested in the preservation of capital should hold mostly bonds. History tells us that this approach may seriously underestimate the substantial, long-term risks of that advice.
In a paper published in 2013 titled, Rethinking Risk, Javier Estrada compares bonds and stocks over different time frames and from different countries. Although bonds do have less short-term volatility than stocks, in the long term they do a much worse job of protecting investors from downside risk. Here’s an excerpt from the article abstract (emphasis mine):
Using a comprehensive sample that spans over 19 countries and 110 years, this article argues that when 1%, 5%, or 10% tail risks materialize, stocks offer long-term investors better downside protection than bonds in the form of a higher terminal wealth. In fact, stocks have both a higher upside potential and a more limited downside potential than bonds, even when tail risks strike.
This study looked at both stock and bond market returns (real returns net of inflation) for 19 countries for a period spanning from 1900 – 2009. The data was further organized into overlapping 10, 20 and 30 year periods. The table below shows which asset class performed the worst during the bottom 10% of these time periods. Outliers are in bold:
| Country | Worst 10% of 10 yr holding periods |
Worst 10% of 20 yr holding periods |
Worst 10% of 30 yr holding periods |
| USA | bonds (-30.6%) | bonds (-33.6%) | bonds (-29.6%) |
| Australia | bonds (-53.8%) | bonds (-52.2%) | bonds (-67.1%) |
| Belgium | bonds (-73.6%) | bonds (-82.8%) | bonds (-75.1%) |
| Canada | bonds (-44.4%) | bonds (-38.8%) | bonds (-28.5%) |
| Denmark | bonds (-34.2%) | bonds (-23.8%) | bonds (-14.8%) |
| Finland | bonds (-84.9%) | bonds (-82.5%) | bonds (-73.8%) |
| France | bonds (-86.1%) | bonds (-90.6%) | bonds (-89.2%) |
| Germany | bonds (-93.5%) | bonds (-93.9%) | bonds (-90.8%) |
| Ireland | bonds (-55.2%) | bonds (-56.1%) | bonds (-61.6%) |
| Italy | bonds (-93.9%) | bonds (-95.7%) | bonds (-95.2%) |
| Japan | bonds (-98.1%) | bonds (-99.1%) | bonds (-98.8%) |
| Netherlands | bonds (-37.8%) | bonds (-49.1%) | bonds (-58.9%) |
| New Zealand | bonds (-45.4%) | bonds (-47.5%) | bonds (-47.9%) |
| Norway | bonds (-52.0%) | bonds (-50.7%) | bonds (-46.3%) |
| South Africa | bonds (-37.0%) | bonds (-48.3%) | bonds (-42.5%) |
| Spain | stocks (-67.3%) | bonds (-56.5%) | bonds (-59.0%) |
| Sweden | stocks (-45.3%) | bonds (-37.1%) | bonds (-45.0%) |
| Switzerland | stocks (-45.5%) | stocks (-32.3%) | bonds (+15.1%) |
| United Kingdom | bonds (-53.6%) | bonds (-50.9%) | bonds (-59.5%) |
Historically, when bonds are bad over a long period of time, they are almost always worse for you than when stocks are bad over a long period of time. Conservative investors don’t need protection from average or good periods, it’s these long, really bad stretches we’re concerned with. The data suggests that the ability of bonds to provide protection during these bad periods has been greatly exaggerated. Overweighting fixed income in the name of being conservative can, and often has, backfired badly.
Just because bonds can be bad for you doesn’t mean you shouldn’t ever use them and it certainly doesn’t mean that the risky things I mentioned at the beginning will be better protectors of wealth over a long period. The meaning that should be taken away from this is that a lot of what investors (and advisors) think they know about how investments are supposed to behave and how portfolios are supposed to be structured are based on assumptions that are wrong.
There is no such thing as one type of investment that will always take care of you. Stocks and bonds and commodities and every other type of security we have available to us are nothing more than tools. They don’t owe us a respectable return in the time frame we need any more than a saw owes us a straight cut line. Rather than selecting a few tools and vowing to stay with them without regard to circumstances, we should think about how they can be best used to our benefit. The focus should be on the job – the desired end result – not the tools.
Investments with more volatility than bonds can be perfectly suitable, even preferable, for some conservative investors as long as three conditions are met:
- There is a reliable protective exit in place.
- Positions are sized to accommodate the volatility of the holding.
- Your investment situation and personality are suited for it.
A Reliable Protective Exit
The key word here is reliable. It’s not enough to just set a sell stop and call it good. Trading in a stock can be halted due to an unusual announcement. Bad news can come over a weekend or after market hours resulting in an opening price the next day well below your exit. Some thinly traded securities can develop very wide spreads between the bid and ask price which could trigger an exit that you didn’t want. The reliability of the protective exit should play a large part in how investments are selected.
To enhance the reliability of my exits, I’m looking for two things before an investment is ever made:
- Focused diversification. I want the volatility of a focused sector or country without the headline risk of a single stock. An ETF or equivalent instrument that offers a basket of related stocks can be a good middle ground between significant upside potential and blunting the damage of something unusual like a CEO being arrested for fraud.
- Liquidity. There has to be sufficient volume in the security to allow a position to allow a smooth exit. If volume is too light, a large position can be nearly impossible to get out of without depressing the price.
Intelligent Position Sizes
The presence of a protective exit dictates that sometimes that exit will be used. Losses will be taken. This reality leads logically to a very important question:
- How large of a loss is OK to take?
Again, we are looking for a middle ground. We want enough money at risk to make a meaningful impact when our investments work out the way we like, but not enough to imperil our survival when they don’t. Taking a loss that costs you 5% of your portfolio is fine in isolation, but what if it happens six times in a row? What if it happens to eight of your positions all at the same time? To avoid trouble, we have to size positions in a way that doesn’t risk ruin during an extended streak or widespread occurrence of adverse outcomes.
Don’t Let the Tail Wag the Dog
The setting of position sizes is where the advantage of volatility is often squandered. A common mistake made by investors is to set their protective exit to the size of the loss they are willing to take. For example, assume a person with a $100,000 portfolio that is willing to to risk 1% on each position:
- Makes ten investments.
- Puts $10,000 into each position.
- Exits position if decline hits $1,000.
The problem with this crude approach is that the investments with the most upside potential are penalized for the quality that gives them that potential – volatility. Rather than treating everything as if it is equal, investments should be sized according to their particular characteristics. For example, below is a comparison of two positions with markedly different levels of volatility. These will remain unidentified, but they are based upon actual examples of current positions:
- Relatively low volatility domestic equity position:
○ current price = $89.07
○ protective exit price = $81.07
○ risk per share = $6.00
○ intended potential decline = 6.7% - Relatively high volatility foreign equity position:
○ current price = $25.02
○ protective exit price = $18.96
○ risk per share = $6.06
○ intended potential decline = 24.2%
Using the same parameters as above, an investor with a $100,000 portfolio willing to risk 1% on each position, our investment sizes are dramatically different:
- Low volatility domestic equity position:
○ $1,000 risk/$6.00 risk per share = 166 shares
○ 166 shares x $89.07 = $14,786 investment - High volatility foreign equity position:
○ $1,000 risk/$6.06 risk per share = 165 shares
○ 165 shares x $25.02 = $4,128 investment
Both investments risk the same dollar amount even though one is more than triple the size. Why the big disparity? Volatility. Actual, measured, volatility. To prevent squandering the beneficial effects of volatility we need to give our investments room to be themselves. If we try to shoehorn them into a narrow range, like the uniform $10,000 investment size in our first example, we will likely stumble into our protective exit simply due to normal variation.
To realize the full potential of the investments we make, we have to tolerate normal ups and downs, but we don’t have to allow a loss to cripple us. So we measure volatility first, then we make allowances for that volatility. We don’t react to the normal range of fluctuation, but we do protect ourselves from moves outside that normal range.
When we do this, volatility and its impact on our portfolio becomes a self-correcting factor. Those positions with the greatest natural variation force a smaller position size and vice versa. We can stay in those risky, high potential, investments longer, with confidence, when we have a reliable exit in place and the consequences of it not working out are managed. This, in turn, allows us to shed reliance on bonds and reduce the risk of a long, catastrophic decline like those shown in the table above.
Your Investment Situation and Personality
A reliance on high quality bonds or other fixed income securities is preferable for funding near term events where a loss of principal is unacceptable. The substantial long-term risk of bonds is just that – a long-term risk. This article focuses on long-term conservative investors and presents an alternate approach to preserving and growing wealth that removes dependence on bonds or any other asset class and replaces it with an active approach to risk management.
In my opinion, this is a superior approach, but it’s not for everyone. Executing this type of plan requires discipline and confidence. Maintaining discipline and confidence depends on realistic expectations and a careful, honest consideration of your objectives and risk tolerance.
All investors, especially conservative investors, owe it to themselves to be vigilant and willing to question widely held assumptions. If you’d like to talk about how an alternate approach might be able to work for you, please call us today.
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Disclaimer: Investments are subject to risk, including the loss of principal. Some investments are not suitable for all investors. Talk to your financial advisor before making any investing decisions. Past performance is not indicative of future returns. Information displayed is taken from sources believed to be reliable but cannot be guaranteed. When you link to any of the websites provided here, you are leaving this website. We make no representation as to the completeness or accuracy of information provided at these websites. All indices are unmanaged and investors cannot invest directly into an index. Unlike investments, indices do not incur management fees, charges, or expenses. Past performance does not guarantee future results. Diversification does not assure a profit or protect against loss in declining markets, and diversification cannot guarantee that any objective or goal will be achieved. Ideas and opinions expressed in this article are the sole responsibility of Patrick Crook/PLC Asset Management and do not reflect any stated opinions of Commonwealth Financial Network, National Financial Services LLC or any other person or entity.