On the dangers of fighting the last investment war
- January 25th, 2013
It is often said that generals are always preparing to the fight the last war. The same thing could be said of investors as well. Investors are prone to extrapolate the recent past well into the future. For example, nearly four years into a bull market only now are investors beginning to put money back into equity mutual funds.
This point is well-illustrated in a series of graphics from David Rosenberg, via Business Insider, showing magazine covers from the most important eras finance of the past two decades. These include the Internet bubble, housing boom and the Great Recession. These compilations show how investors become slowly convinced as to the inevitability of the trend at hand.
In terms of trends there are few more well-established than the bond bull market. For over thirty years now bond yields have done little more than go down. Maybe because the trend has been so long-standing there is no cluster of magazine covers to highlight it. However a look at the graph below shows just how far yield have come from the end of the highly inflationary decade of the 1970s.
Some investors are taking notice that this downward trend in interest rates at some point has to end. Josh Brown at the Reformed Broker notes how the big bond mutual fund shops like Pimco and DoubleLine are ratcheting up their equity fund offerings to take advantage of what might very well be expected to be a change in interest rate regimes.
It has also brought out some skeptics of bond heavy, risk parity strategies.* What is a risk parity strategy? Michael Corkery at WSJ provides some background its growing acceptance.
A core tenet of risk parity is that when stocks are falling, bond prices typically rise. By using leverage, bond returns can help make up for losses on stocks. Without leverage, bond returns in a typical pension portfolio of 60% stocks and 40% bonds wouldn’t be large enough to compensate for low stock returns.
Leo Kolivakis at Pension Pulse notes risk parity strategies are more than just leveraging up bonds. However the heavy emphasis on bonds is what is giving some writers pause. Roger Nusbaum at Random Roger thinks the demise of risk parity is likely off a few years. However Stephen Gandel at Fortune is skeptical about the idea that leveraging up an asset at the end of a multi-decade bull market is necessarily a good thing. He writes:
But it’s also just the type of talk – that something like levering up your portfolio is safe as long as you use that leverage to buy bonds – that always pops up, and gets taken as gospel, just as bubbles are about to burst.
The bond bull market has gone on, with the help of the world’s central bankers, longer than most anyone would have believed in 1980, 1990 or even 2000. However at a time of calm bond markets and supportive equity markets, investors have the chance to think ahead to how a sustained rise in interest would affect them and their portfolios.
Things change. Bull markets end. Sometimes quietly, sometimes not so quietly, see the stock market implosions of 2000 and 2008. Investors need be sure they are not fighting the last war but are looking ahead to the next one. The bond bull market will end some day and strategies over reliant on an interest rate tail wind will suffer. The big bond market guys are looking ahead. So should you.
*For a more technical take on the theory underlying risk-parity strategies see: Asness, Pedersen and Frazzini, “Leverage Aversion and Risk Parity,” Financial Analysts Journal, January/February 2012.
Abnormal Returns is a participant in the Amazon Services LLC Associates Program, an affiliate advertising program designed to provide a means for sites to earn advertising fees by advertising and linking to Amazon.com. If you click on my Amazon.com links and buy anything, even something other than the product advertised, I earn a small commission, yet you don't pay any extra. Thank you for your support.
The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.
Abnormal Returns has over its seven-year life become a fixture in the financial blogosphere. Over thousands of posts we have striven to bring the best of the financial blogosphere to readers. In that time the idea of a “forecast-free investment blog” remains as useful as it did six years ago. More »
- Tuesday links: gimmicky guidance
- Monday links: global market turbulence
- Top clicks this week on Abnormal Returns
- Saturday links: the halo effect
- Friday links: all the tools you need
- Podcast Friday: personal investment policies
- Thursday links: spend a little
- Why volatility matters
- Comparing the robo-advisors
- Wednesday links: the end of the relentless bid