Reason #3 – Investments are Too Closely Correlated to the Stock Market
Surprise newsflash…MARKETS HAVE RISK.
Okay, not surprising perhaps.
So why do so many investment managers fail to plan for significant market volatility or stock market crashes?
It really just boils down to what their motivation is. You see money managers, such as those that manage money within mutual funds and pensions are all competing for your business.
But not the way you might think. They’re competition is more with other investment managers than it is in providing the best investment returns for you as investors.
Seems crazy right?
Let me explain how this happens.
Let’s take a typical bond fund manager. He has just been hired to help manage the fixed income portion of a mutual fund or pension plan.
So what really is his objective?
It should be to collaboratively invest with the other asset managers and provide the best risk adjusted return possible for the investor….OVERALL.
But this seldom is the case.
Instead, this manager competes with other bond managers all while trying not to risk losing the opportunity of managing money for the pension plan. The easiest way to risk this is to sway too far away from his or her peer’s performance. And therefore plays it very conservative within his approach.
This is the absolute worst thing that can happen because it leaves the investor significantly to severe market risk.
Bonds will ALWAYS underperform equities over the long term. This is just economic fact. If it wasn’t, then there would be no need for anyone to invest in stocks and we would all just own government and corporate debt. But because there is more risk in owning stocks over bonds, investors are rewarded over the long term by choosing equities.
So the key is to own as much equity exposure as possible with the least amount of risk.
Therefore, the only reason a portfolio manager should have an allocation of bonds is simply to protect the portfolio during periods where stocks do not perform well.
So why would a bond manager worry about underperforming other bond managers when his sole job within the pension or mutual fund is to protect the portfolio from equity risk?
Because that is how they are evaluated.
It’s a vicious cycle.
The end result for the individual investor is an investment portfolio that is too closely correlated to stock markets. Often higher than 90% correlated!!!
This means that if the stock market drops by -20% that your investment portfolio will drop by -18%.
For example: A bond manager might speculate on the direction of interest rates. The longer the duration of the bond investment the more sensitive it is to increasing interest rates. Put another way, a 10 year bond is far more sensitive when compared to a 1 year bond.
But this should need not be a worry for the bond manager. Because the more sensitive the bond to interest rates the more NON-correlated it is to stock markets. And as a result the more protection an investor would receive in the event that equity markets sell off significantly.
And subsequently the less that the investor needs invested bonds for the same protection.
So how would this be avoided….By having both equity managers and bond managers simply stay in their lanes and do their part for the greater good….That being the overall portfolio performance for the investor…
By choosing bonds that are more sensitive to interest rates and therefore the most NON-correlated to stock markets the portfolio should be best protected. Put another way….Bonds that lose a lot of money when equity market flourish and make a lot when stocks flounder.
Without any acknowledgement to what other bond managers are considering.
But this takes discipline and patience.
Something competing pension managers often lack.
Precedence Capital / Gravitas Securities Inc.
The views, opinions and positions expressed by the author and those providing comments on these blogs are theirs alone, and do not necessarily reflect the views, opinions or positions of Gravitas Securities Inc.