Bonds and Rebalancing

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New clients at Telarray are offered a session at the beginning of our relationship to discuss the Telarray approach to investing. It’s a lot to process in an hour or two, and we know that there may be questions as our relationship develops.  

Of course, you may call your Advisor at any time with any of your questions, but we thought a multi-part series discussing our approach to investing might be helpful. Last time, we discussed the value of international diversification. Today we discuss the importance of an allocation to cash and bonds and the magic of rebalancing.  

In previous parts of this series, we’ve discussed how we select various types of investment funds for our Telarray portfolios.  Here, we’d like to discuss what happens after all the components are chosen and it’s actually time to manage the portfolio.  The answer really comes down to two things — selecting a prudent bond allocation, then rebalancing appropriately going forward.

It’s hard to find a long period of time where a 100% stock allocation looks bad compared to bonds or even cash.  As years turn into decades, an investor “all in” on stocks would have almost always done dramatically better than almost any other alternative.  So why do prudent portfolios have sometimes sizeable allocations to bonds? 

For one thing, as an investor prepares to start taking withdrawals from the portfolio, a large market downturn could result in that investor selling their seed corn and not taking advantage of a big recovery after the downturn.  This “sequence of returns risk” is very real for recent retirees and those thinking about retirement in the next few years. 

For younger investors, it can still be hard to stick with 100% stocks in a downturn despite having the runway to recover from it.  Besides, the future won’t look exactly like the past, so at least a small bond allocation probably makes sense no matter how young you are and how attractive stocks are for the long run.

There’s an old saying that is used again and again with asset managers — the idea they can “participate on the upside and protect on the downside.”  This result is actually easy to achieve by simply keeping a sizable portion of the portfolio in cash.  50% cash?  Your drawdown will be exactly half of the market’s drawdown, but unfortunately, your upside will also be only 50% of the market’s upside when it rallies. 

That idea is a little disingenuous when you’re pitching an investment product, but makes a lot of sense when managing an individual investment portfolio.  The idea of giving away upside in exchange for reducing the possible downside is one of the most basic financial concepts, be it through insurance, optionality, or simply reduced exposure to the market.  An increasing exposure to cash and bonds will likely reduce your performance long-term, but will also reduce drawdowns in challenging markets.

The value of cash and bonds is real, regardless of what the bond bears might say.  While the expected return for bonds is lower than probably at any time in recent memory, bonds still serve a critical role in our portfolios. 

The value of these bonds from a risk management perspective is twofold.  Not only should bonds typically reduce the drawdown of the portfolio in a market crash, but they provide a source of cash to buy low and sell high.  With a given allocation of say, 60% stocks and 40% bonds, a big stock market downturn would make the stock percentage meaningfully less than the 60% target.  That would mean that some of the bonds would have to be sold in order to buy more stock.  This sort of rebalancing transaction might seem immaterial, but a disciplined rebalancing plan is one of the only ways to systematically buy low and sell high and can provide a significant boost to a portfolio’s return in the long term.

It can be hard to stay invested when the future seems uncertain in the stock market—but the future always looks uncertain in the stock market.  Rather than jumping from an investment portfolio to cash and back, we recommend establishing a cash and bond allocation that makes sense in good times and bad.  From there, the magic of rebalancing performs the hard work so that our clients and advisors can focus on the important work of financial planning without frustration from the Sisyphean task of active market timing.


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