Adding A Risky Asset To Reduce Risk In Your Portfolio
Modern portfolio theory, the idea that the efficiency of investments can be managed by diversification of asset classes, was introduced in 1952 then popularized by a book at the end of that decade. For over 50 years, the theory has been believed to have been proven correct as portfolios with a blend of assets (primarily equities and bonds) have smoothed out the ride for investors. If you have ever worked with a financial advisor, I’m sure you’ve seen one of these.
Great results over this tumultuous decade, but take a look at this and consider the value of 40% of your money in bonds.
As you can see, after accounting for inflation, returns over an extended time period would have been significantly better if the portfolio had been all equities, but the lower volatility provided by steady old bonds gave better returns over a troubled decade. I don’t intend to get into a detailed critique of portfolio theory here, but one of my first articles for NASDAQ.com dealt with a common mistake when assessing risk; volatility and risk are not necessarily the same thing. In this case, an argument can be made that the historical lack of volatility in bonds is exactly what increases the risk to a classic balanced portfolio going forward.
Bonds have been a one way bet, as evidenced by the grey line on the above chart, since around 1980. Since interest rates peaked in the 1980’s the move down in rates has been steady and sustained. It is somewhat confusing to some, but lower interest rates mean higher prices for bonds. The interest on a bond is fixed at the time of issue and if prevailing rates subsequently fall then a $1000 bond that pays, say 10% interest will keep paying that $100 per year, even if rates fall to 5%. It then becomes worth paying more than face value ($1000) for that bond in order to get that $100 annually, and the price of the bond goes up.
This has been happening consistently, so bond holders have been doubly rewarded and cushioned against any fluctuations in the stock market. They have been receiving steady, if declining, interest payments and the value of their holdings have been increasing. This steady increase in bond value is what has led to reduced volatility in a traditional investment portfolio that had, for example 60% stocks and 40% bonds.
Remember, though, volatility does not equal risk. As the Federal Reserve has begun to talk about “tapering” QE, so rates have begun to gradually rise from their artificially maintained lows. The rise in rates, by the nature of the bond market, is unlikely to be steep and sudden, causing a collapse in bond prices, but it will come.
I’m not talking about a return to the 1980’s and interest rates in the high teens, but rather just a normalization, a return to a 4-5% yield on the US Government 10 year. The point is that this is likely to happen slowly, over a decade or so, and if that is the case it poses a problem for portfolio theory adherents. If the asset class that is there for stability (bonds) is in a gradual decline it serves the opposite purpose and increases any loss from stocks.
Of course, some degree of diversification is desirable, if only because your Mother told you never to put all of your eggs in one basket, but traditional bond investments don’t look like the long term answer to that need. I would consider commodities, REITs and international stocks to some extent, but if you want to stay true to the spirit of Modern Portfolio Theory, then buy some bonds; just not US bonds. Emerging market bonds are volatile and therefore considered risky, but when compared to an asset class (US bonds) that appears programmed to gradually lose value, the “risk” seems less.
Obviously, for individual investors, there are all sorts of problems in buying individual bonds from emerging market nations; currency risk, difficulty of research and lack of transparency in some companies are just the beginning. This would be an area, therefore, where paying fees to a fund manager makes sense. A decent emerging market bond fund, such as the Franklin Templeton Emerging Market Debt Opportunity Fund (FEMDX), or the Fidelity New Markets Income Fund (FNMIX), could provide the answer.
Where this contradicts the traditional theory and conventional wisdom is that these funds are likely to be volatile over short time periods, but their potential lack of correlation to US equities or bonds may serve to diversify enough to even reduce the volatility of the total portfolio over time.
Modern Portfolio theory won’t die over the next decade or so, but to make it work for you, you may have to look beyond the traditional components.