There is always a trade-off between the return sacrifice and diversification benefit a strategy brings to a portfolio. Long-dated bonds and treasuries in particular, have demonstrated strong diversification benefits in portfolio construction because of their negative correlation to other asset classes, like equities.
Widely accepted ways of measuring risk simply do a poor job of showing it. Risk encompasses the multitude of scenarios an investment could deliver, not the single path that ends up being measured afterward. In other words, volatility, standard deviation (and the many ways they are sliced and diced in risk management models) tells us what has happened, not what might have happened or could happen in the future.
Bonds are the parachutes of the investment world; they have offered safe, stable income and their prices generally go up when everything else goes down, giving them a nice defensive quality in portfolios. Falling interest rates are the wind that keeps the parachute open and the greater the duration (interest rate sensitivity), the softer the landing.
Bonds are exposed to interest rate risk and the greater a bond’s duration, the greater the sensitivity to that risk. Perhaps more importantly given the current interest rate environment, the more rates fall, the more that risk rises exponentially.
Asset allocation was intended to be a means by which to diversify, not an end in itself. Despite ample examples of how insufficiently asset allocation diversifies risk – the Fall of 1998, the dot-com crash of 2000, the high yield debt rout of 2003, the credit crisis of 2008, and so on – the industry overwhelmingly continues to use it as the primary means by which to build portfolios.
At Rain, we start with the premise that risk considerations should drive capital allocation, rather than letting capital allocation drive portfolio risk. This means that the building blocks of our portfolio construction are the direct risk factors that drive asset valuation like inflation, economic growth, interest rates, liquidity, volatility, and so on.
The relationships that made asset allocation an effective way to diversify have changed. Correlations between most asset classes have been creeping steadily upward since the mid-1990s.
Investors have been told investing across different asset classes (known in the industry as asset allocation) is the best means of diversifying their portfolio, yet they continue to experience violent swings in the value of their wealth with each successive crisis.
Humankind innovates faster than we can solve the problems our innovations create. Wall Street is a case in point. What started with simple barter between individuals who produced goods each other wanted, evolved into trading shells, beads, commodities, coins, trade bills and so on ad nauseum.
