Balanced investment vehicles: a skewed reality part 1

There is a skewed reality where “all is going to be OK”, because we can rely on the past to save us!

I keep on seeing comments in the media and from consumer focussed financial periodicals to the effect that investors who buy and hold balanced portfolios will always come through and eventually returns will beat previous highs, and investors should not worry.  This is both overly simplistic and worrying!

Part of the lesson about balance remains true: that is if you hold a portfolio balanced according to your risk and liability profile, and which relies on conservative assumptions for its ability to meet financial needs, then you can worry less under normal conditions and with provisos.  But it does not mean that portfolio returns will always recover and it does not mean that you will experience a superior risk/return profile going forward.

Part of the lesson about rebalancing also remains true, that if you sell another asset relatively high and and buy another relatively low that the resulting return will be superior.  

But, I would draw attention to the peculiar investment environment of the last 20 + years in particular. 

We have had a slowing of growth and an increase in debt at the same time as we have had a consistent fall in interest rates and bond yields. We have had historically high profit levels and equity markets that have oscillated between highs and lows providing dividend reinvestment  and rebalancing opportunities.

Portfolios that have had significant allocations to bonds have benefited from a low risk asset class that has behaved more like an equity than a bond.  Additionally while equities have zigged and zagged, they have regained prior highs and provided good rebalancing opportunities.    Balanced vehicles have benefitted. 

But, we need to realise two things:

The first is that past returns are not drivers of future return, and secondly that the dynamics of the last 20 or more years (in particular since 2000) cannot be guaranteed to be repeated and are in themselves highly unusual:

image

We see, if we reference the US market and US 10 year bond values, that as the capital value of the equity market fell from 2000 to 2003 and from 2007 to 2009, that the decline was offset and the portfolio supported by a rise in bond market capital values.   This rise in bond values is not sustainable and is building up a significant risk to balanced portfolio returns.

The above chart does not of course show reinvestment of dividends and bond coupons, nor does it show transaction and management costs, the impact of taxation, or any rebalancing.    It is a straightforward 40% of the capital value of a 10 year bond + 60% of the capital value of the market assuming a starting index of 100.  The bond is rolled over to maintain a 10 year duration but also to reflect falling starting coupons.

What concerns me is that the cycle can only really be perpetuated if bond yields continue to decline.  A rise in economic growth would necessitate a rise in the return on fixed interest capital for newly issued bonds resulting in a decline in bond prices.  On the other hand, the North American equity market in particular has high P/E ratios and high historical profits levels as a % of GDP.   There may well be little give on the equity side and little room for additional explosive bond returns.

There is no certainty, only risk and return in differing combinations.   Again too many commentators are talking are talking in far too simplistic terms whenever well diversified portfolios are discussed in a risk/return context.  The last 20 years in particular has seen significant debt and structural imbalances built up as central banks have attempted to deal with economic risks by lowering interest rates and pumping up asset markets.

I will develop this discussion in subsequent posts…

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