Trading One Risk For Another

I was in Chicago last week visiting our new office (awesome location in the West Loop). I was there with Barry Ritholtz and Kris Venne meeting clients and prospects and visiting with our new colleagues Brian, Jonathan, Anna, and Colleen.

Barry was out of the office all week so he was running older posts from the other blogs on his site and asked me to offer up one of my own favorites.

I immediately thought about my post on the misconceptions about individual bonds vs. bond funds. For some reason, investors have very strong opinions on this topic and it always drives some discussion and emails whenever it’s brought up.

Investors have been worried about rising rates for years (decades?) now, so this argument is always framed in terms of how a portfolio of individual bonds would fare versus a bond fund in such an environment. My take is that a bond mutual fund or ETF is simply a collection of individual bonds. The duration, maturity, credit quality, and yield can certainly be different when comparing individual bonds to bond funds, but it’s all the same thing when you really think about it.

As expected, I received a number of emails telling me I was wrong on this topic yet again. Some people simply like the idea of holding bonds to maturity because “they know exactly how much money they’ll receive.” Others are worried that a rush to the exits from investors could cause short-term losses in bond funds. Still others think a bond ladder of individual bonds is the best way to go.

I could walk you through the nuts and bolts of each argument but I’ll spare you the details (if you’re interested read my original piece or this whitepaper from Vanguard). The main thing to remember about this argument (or really any investment decision you make) is that there are always trade-offs. Risk never completely disappears in a portfolio because suppressing one risk just means you’ve opened yourself up to another.

Holding a portfolio of individual bonds means you know exactly what you’ll be getting at the maturity of those bonds. But you still have to deal with reinvestment risk and your individual bonds will still get marked-to-market in the meantime. You still have to deal with the risk of inflation.

If interest rates fall will you be tempted to sell the bonds and lock in a decent up-front return? Who will trade the bonds on your behalf? How many individual bonds do you need to be diversified? If you’re reinvesting your bond proceeds, didn’t you just create a de-facto bond fund?

This trade-off in risks occurs with other aspects of portfolio management as well:

Allocating more money to stocks gives you higher expected returns but higher expected volatility and a larger drawdown profile.

Allocating more money to bonds gives you lower expected returns but lower expected volatility and a smaller drawdown profile.

Allocating more money to cash offers optionality but cash loses money to inflation over the long haul and timing the market is hard.

A focus exclusively on yield can lead investors to ignore total returns.

Seeking safety in the short-term can help you sleep at night now but it also means you won’t live as well in the future.

High-quality bonds can save you from large nominal drawdowns but they open you up to the risk of inflation-adjusted losses.

Waiting for the proverbial “fat pitch” sounds appealing until you realize how psychologically challenging it can be to sit in cash while markets rise or how difficult it is to put money to work when stocks are getting crushed.

Diversification is a wonderful form of risk management over the long-term but can make you feel exceedingly stupid for not investing in the best performing asset class each and every year.

Hedge funds and private equity only mark their holdings to market on a monthly or quarterly basis. This is great for academic risk-adjusted return formulas but masks the actual volatility of the underlying holdings.

Volatility is a poor definition of risk for a portfolio because it tends to be short-lived in the markets which is true until it causes you to make an irrational short-term decision with long-term capital.

Investing in stocks over 20+ years has given investors a high probability of seeing a premium over bonds most of the time but not always.

Investing in a concentrated basket of cheap, high-quality companies with a built-in margin of safety is one way to outperform the market. It’s also an easy way to severely underperform.

A trend-following strategy trades decreased downside volatility and drawdown risk for whipsawed trades and false-positive trading signals.

In other words, investing is hard. If it was easy it would just be called earning money, not investing.

You cannot eradicate risk in a portfolio. You can only choose when and how to accept risk in different variations. Doing so will always involve balance and trade-offs.

Further Reading:
Three Misconceptions About Risk Management

 

 
Download PDF

Full Disclosure: Nothing on this site should ever be considered to be advice, research or an invitation to buy or sell any securities, please see my Terms & Conditions page for a full disclaimer.