Driving in the Rearview Mirror?
Investing is sometimes counterintuitive. In many aspects of life, making decisions based on extrapolating the recent past makes a lot of sense. For example, if you are trying to predict who will win the NBA championship next year, you could do worse than selecting either the Cleveland Cavaliers or the Golden State Warriors (especially now that Kevin Durant is on the roster). The fact that these teams squared off in the recent NBA finals and retained their best players is probably a good indication that they will be pretty decent next year. Or, if you are trying to guess which swimmer will perform well in the Olympics, given his decorated past, Michael Phelps is probably not a bad choice. To use a non-sports example, if you’ve driven a Nissan Altima for 15 years and over 250,000 miles with minimal problems, you would likely conclude that Altimas are quality cars and may consider buying another one. Making these types of decisions in this way is logical and easy to understand.
Investing, on the other hand, is a different story. One of the common refrains we hear from individuals when discussing portfolios is the desire to buy more of what has recently done well and sell what has performed poorly. Just like picking the Cavs to win it all next year, Michael Phelps to win gold, or recommending a car that you’ve driven for 15 years, this sounds very rational on the surface. However, this is often not the case when it comes to investing. The reason for this is thatwhen the price of an asset rises, unless the increase is accompanied by improving fundamentals, then the riskiness of that asset has increased.
Probably the best example I can think of at the moment is the bond market. Generally speaking, bonds are perceived as “safe” investments and sought out by conservative investors due to a long history of providing low volatility with steady returns. Over past one, five, and ten year periods, the Barclays US Aggregate Bond Index (common index of investment grade bonds in the US) has returned 5.94%, 3.57%, and 5.06% per year on average.1Even better, when the stock market crashed in 2008 and barely budged in 2011, the index provided strong gains in both years. As we’ve written about before, bonds have been in a bull for 35 years. Investors have been conditioned for a generation to view bonds as safe and steady; so much so that now some bonds have negative yields to maturity. A June 24th headline on NPR’s website reads: “Bonds Pay Less than Zero as Investors Flee to Safety.” The article quoted Dartmouth Professor David Branchflower: "People are looking for safety. They’re looking for places to park their money."2 How anyone can view a security as "safe" that is guaranteed to produce a loss is beyond me. If a guaranteed loss isn’t risky, then I don’t know what is.
Currently, the yield on the Aggregate Bond Index is close to the lowest in history yet its current duration (a measure of interest rate risk) is the highest in many years. In other words, investors in the index today are exposing themselves to more and more risk for less and less return. This is hardly a definition of safety. Famous investor Howard Marks refers to this phenomenon as “the perversity of risk” meaning that a perception of safety can lead people pile in and bid up the price, thus increasing risks.3 We believe this is what is happening today in the bond market, especially for long-term sovereign bonds.
As the risk of owning bonds increases as rates continue to decline, we believe active management should play an increasingly greater role for bond portfolios. With the incredibly low yields on sovereign bonds across the globe, it is important for bond investors to “pick their spots” rather than passively owning an index and simply accepting its increasing duration risk. Bonds can and do still play a role in the portfolio of certain investors, but the risks must be acknowledged. Now more than ever it is crucially important for investors to drive while looking out the windshield, not gazing in the rearview mirror.
Let me give a caveat by saying that just because an asset has increased in price does not always mean the risk has increased. For example, you could have purchased stock in Wal-Mart in 1995 even after the price had risen astronomically, and still done very well. This is because Wal-Mart continued to increase in value over the years as it grew. The key is that risk didn’t increase as the price rose because the rising price was justified by a business that was growing valuable with each passing year. However, in other cases, when an asset performs well, it absolutely becomes more risky and the last thing you want to do is buy more of it and compound your risks.
1Returns as of 7/31/2016 (https://www.ishares.com/us/products/239458/AGG?referrer=tickerSearch#/)
2http://www.npr.org/2016/06/14/482044543/bonds-pay-less-than-zero-as-investors-flee-to-safety
3https://www.oaktreecapital.com/docs/default-source/memos/2015-09-09-its-not-easy.pdf?sfvrsn=2
