At this very moment, some advisor, somewhere in the securities industry, is confronting a difficult reality with their clients.
They know that bonds are often as risky as stocks, and that stocks and bonds often behave like each other. Yet, there is often little they can do for clients outside of the traditional balanced portfolio that is often dictated by a client’s age. Those constraints reflect an unforgiving amalgamation of suitability rules that are enforced by rigid compliance departments even though they often make less sense than the ideas from the 1950s that still dictate how money should be invested to reduce risk.
We were reminded of these difficulties during a recent conversation with a top advisor. He was frustrated at not being able to properly care for a client who had just sold a piece of jewelry for a few million dollars. The client wanted to invest in the equity market, but the advisor thought stock prices were too high. He did not feel comfortable investing in bonds, which he said – and we agree – are rather risky as the Federal Reserve is in the midst of raising rates. The advisor wanted to sell downside puts on blue-chip stocks that pay dividends, which is a way to buy stocks below market prices, but he knew compliance would block that even though his client was wealthy. Why? The client was in his 70s. So, rather than fighting the compliance department, he put the money in a cash account where he could wait for an opportunity rather than slotting the money into some allocation that a compliance clerk would approve.
“The Street was built on 60/40,” he said, referring to the widespread idea that portfolios that are divided between 60% in stocks, and 40% in bonds have superior risk-adjusted returns
Perhaps that was true in the past, but it is less true at the present moment as the Federal Reserve is trying to extricate itself from the easy-money policies that helped save the global markets from destruction.
Is Your Portfolio Truly Diversified? Probably Not Click To Tweet
According to one chart making the rounds, the traditional 60/40 portfolio returned about 14% during the 1990s with a 9% volatility. Now, the strategy is not about half as effective and volatility is slightly higher, and the portfolio basically behaves like a stock portfolio.
In other words, the supposedly balanced portfolio is no longer so balanced.
Moreover, international stocks, which have helped to diversify and hedge U.S. portfolios, are also less effective. As globalization, and electronic trading has linked markets and economies, many once diversified assets are trading like each other. The phenomenon is often evident on a daily basis. Bad news in one market rolls around the world, knocking down stock prices likes a chain of dominoes. Some investors, like our advisor friend, are waiting for the proverbial shoe to drop.
“What happens when stock go down, and bonds go down? We know rates will rise and bonds will go down,” he said. “How do we handle that? How do we deal with compliance?”
The answer, at least at corporate levels, is increasing legal reserves in anticipation of lawsuits that will be filed when the bear market hits. At the advisor level, one answer is finding technological tools to determine the effectiveness of a portfolio’s diversification. This is done by measuring correlation, which is a key concern of institutional investors even though many advisors and individual investors rarely hear about it.
Correlation measures relationships between different investments; it ranges from -1 to +1 (securities move in lock step, which often happens during risk-on episodes). Positively-correlated investments rise or fall in unison. Negative correlation means the move in opposite directions. When there is some kind of risk event – say a trade war that drives stock prices lower all over the world – institutional investors say the world has gone to one. In short hand, that means correlations are high, and there is no safety to be found in markets.
Now, correlations are elevated, a fact that will surprise many people because this type of narrative – even though it is critical to one’s investment health – is almost always absent from mainstream discussions of markets. We believe investors and advisors should regularly review the effectiveness of their portfolio’s diversification. This is especially true as some advisors, and many institutional investors, are now wondering if balanced portfolios that are so commonly recommended really balance risk and reward. We consider correlation levels as a key part of our risk-management framework, and one of the must have conversations between advisors and clients. After all, as we like to say, the hedge preserves the edge. But what if there is no hedge in the hedge? Then, many investors might own so-called “Texas hedges” that increase risk rather than reducing risk.
Bottom line: Know what you own and manage risk to maximize returns.