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Graham Westmacott CFA

Portfolio Manager

Susan Daley CFA

Associate Portfolio Manager
Contact
  • T519.880.0888
  • 1.877.517.0888
  • F519.880.9997
  • The Marsland Centre
  • 20 Erb St. W,
    Suite 506
  • Waterloo, Ontario N2L 1T2
August-20-13

Why Buy Bonds?

Investors who want only winners in their portfolio do not have a winning strategy. The current debate about falling bond prices is a timely illustration.

We all expect interest rates to rise and bond prices fall as interest rates rise. So, why buy bonds?

Tennis anyone?

To answer this question we would point to an article1 written 37 years ago by Charles Ellis called “The Loser's Game”. Famously he pointed what some people still refuse to accept, despite nearly four decades of evidence. Ellis drew a parallel between investing and tennis. Most people lose at tennis through unforced errors trying to despatch the opposition with an ace serve or a stunning cross court volley that ends up on the wrong side of the line. Too many risks are taken that do not pay off. In contrast, the successful tennis player keeps the ball in play until her opponent makes a mistake.

Building wealth is similar. Success comes not from buying a bunch of stocks and hoping that winners exceed losers. Success comes from addressing the risks that may threaten the value of your investments and then capturing what the markets offers. Specifically,

- capitalism is about providing capital to firms that produce profits that not only repay shareholders and debtors but also allow for re-investment.  In the jargon, investing has to have a positive expected return for capitalism to function.

- investors will get their return, if they don’t make unforced errors.

- unforced errors arise from exposure to risks that could have been avoided at no, or at least a modest, cost. 

Investing in a few stocks, when equity diversification is easily achievable though index funds or ETFs, is an obvious example of risky behaviour. Other risks include the risk of inflation eroding portfolio purchasing power, the risk of companies becoming unable to repay their debts, the risk of large scale economic recession, and the risk of changes in interest rates, to name a few. By blending different asset classes we build a robust portfolio in anticipation of the stresses it will be subject to. On this subject, Ellis, in a more recent article, quotes from the Chinese general Sun Tzu’s Art of War “The skillful commander takes up a position so he cannot be defeated. Thus a victorious army wins its victories before the battle”. As Ellis points out, war is the ultimate Loser’s Game.

Bonds keep you in the game

This brings us back to the role of bonds. To think of bonds entirely in terms of their prospects for either short term returns as an asset class, or as a contributor to the overall portfolio return, is to miss their key role in protecting against downside risk.

By way of illustration, we compared a 40% bond, 60% globally diversified equity portfolio with a 100% equity portfolio since 1994 (the longest available data for the portfolio we chose3). The bonds:

  • reduced the final value of the portfolio by 5%
  • reduced the overall portfolio volatility by 38%
  • reduced the worst fall in value over 1 year by 39%
  • reduced the worst fall in value over 3 years by 52%

For a modest (5%) reduction in final wealth, the bonds provided significantly better downside protection when the portfolio was under the most stress. This is a worthwhile trade-off for most investors, but particularly for those in retirement who want to draw a steady income from their portfolios.

To illustrate, we considered the case of Alice and Bob who each had a retirement portfolio of $500,000 at age 65 and wanted to withdraw $30,000 annually until age 90. Alice was 100% invested in global equities while Bob chose to invest 40% in bonds and 60% in global equities, as in our previous example. Despite the higher average annual return of Alice’s equity portfolio (8.53%) compared with the Bob’s portfolio return of 7.72%, the chances of Bob’s portfolio surviving to age 90 is actually higher than Alice’s due to the countervailing impacts of lower portfolio volatility and better downside protection from the bonds.

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Notes
  1. The Loser’s Game, Charles Ellis, Financial Analysts Journal, Vol 31, #4, July/August 1975
  2. Lessons on Grand Strategy, Charles Ellis, Financial Analysts Journal, Vol 69, #4, July/August 2013
  3. The 40% bond portfolio was represented by 40% DEX Global Bond Index and 60% DFA Global Equity index. The 100% equity portfolio was represented by 100% DFA Global Equity Index. For Alice and Bob’s retirement simulation we assumed a $30,000 annual withdrawal and a 1% management fee.  
By: Graham Westmacott | 0 comments
August-20-13

How to Read the Market Stats (Part II)

Just as a cake has a recipe with specific ingredients, a portfolio needs a plan with a blend of specific asset classes to manage risks and meet investment goals.

The Market Stats show the performance of a number of benchmarks that are organized by asset class. It is important to understand exactly what an asset class is in order to utilize that information in building and maintaining a portfolio. 

What is an Asset Class?

An asset class is a group of securities that exhibit similar risk and return characteristics and are subject to the same laws and regulations. In other words, securities in one asset class will behave similarly, on average. There are typically thought to be two main asset classes: income and equity. These asset classes are often broken down into other categories that behave similarly, while assets in different categories exhibit slightly different behaviour. The first categorization of asset classes is often by geography. As you can see in the Market Stats page, PWL breaks down the two asset classes further into Canadian Income and US Income, and Canadian, US and International Equity.

The next type of categorization is between large and small cap stocks. Small cap stocks often behave similarly to each other, and differently from large cap stocks. For example, the S&P/TSX 60 Large Cap has a 1-year return of 8.16% and a 5-year standard deviation of 16.69% while the S&P/TSX Small Cap Index has a 1-year return of -1.02% and a 5-year standard deviation of 23.73%.

What does large cap and small cap mean? Large cap means that the market capitalizations (i.e. total # shares outstanding x market price) of the companies in the index are the largest in the market.1

Another typical asset class category distinction is between value and growth. 

Value stocks are those that tend to trade at lower prices relative to their fundamental valuations (dividends, earnings, sales, etc.) and are therefore considered to be undervalued. Common characteristics include a high dividend yield, low price-to-book ratio and/or low price-to-earnings ratio2.

Growth stocks are companies whose earnings are expected to grow at an above-average rate. They typically do not pay dividends so that they can reinvest earnings in capital projects3.

Why Asset Classes?

A well structured portfolio is composed of a mix of asset classes that respond differently to a particular risk. Investors should be concerned about the performance of their overall portfolio and its ability to meet their goals which can be measured by risk and return. At any particular moment, there are many different risks (equity risk, currency risk, interest rate risk etc.). Each investor has different tolerances to risk depending on their goals, stage of life, personal tolerances and so forth. Our primary tools for managing the overall risk are assets. Specific asset classes address specific risks, and therefore the allocation between different asset classes gives us the ability to manage risks within a portfolio to meet certain goals.

Simply looking at the asset classes on their own, not in the context of a diversified portfolio, tempts investors to remove negative performing assets classes (the “losers”) and invest those proceeds in the high performing assets (the “winners”). This is chasing performance, and is likely to lead to the behavioural trap of buying high and selling low, which can be detrimental to achieving investment goals.

Take the example of baking a cake. Each ingredient serves a specific purpose, and there is an exact combination of ingredients needed to bake the cake. You might really like the taste of eggs, but if you just used eggs, you’d be making an omelette and not a cake. Baking powder is used as a leavening agent. If you don’t put enough in, your cake won’t rise and you will end up with a flat, dense cake instead of a light, fluffy cake; use too much, and you’re cake will end up tasting bitter. Finally, the rest of the ingredients depend on the type of cake you are baking, and your flavour preferences (some people love the taste of coconut, some people hate it).

The eggs show the concept of diversification. A well structured portfolio uses multiple ingredients (or asset classes) to achieve the expected outcome. The baking powder emphasizes the need for a well-designed portfolio asset allocation. Some assets are necessary for the final product yet do not look attractive on their own. Blending the asset classes in particular ways ensures that you can capture most of the returns of the asset classes the majority of the time. If you were to use more eggs (winners) and remove the bitter tasting baking soda (losers), you would end up with a rubbery, flat cake. Finally, the different types of cakes demonstrate that not every investor is the same. If everyone had the same preferences, there would be one perfect cake. If every investor was the same, there would be one perfect portfolio. You wouldn’t think of baking a cake by throwing a bunch of different ingredients into a pan at random and baking it, so why would you do it with your investments?

The Market Stats page reminds us that assets, to be of any use to us, should behave differently over the period under consideration. All the assets listed have a positive long-term expected return, but to be truly diversified means that some will always be outperforming others.

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Notes
  1. The amount of large companies in the index varies for each market/index.
  2. Source: Investopedia. http://www.investopedia.com/terms/v/valuestock.asp
  3. Source: Investopedia. http://www.investopedia.com/terms/g/growthstock.asp
By: Susan Daley | 0 comments