Understanding Risk: The Role of Bonds

What is the most important decision for the long-term investor?

This is actually an easy question, but most investors get it wrong. You need to choose the right level of risk!

Here are the key facts:

1. Even in the best market years there is often a serious "correction" during the year.  Since 1980, the average intra-year decline has been 14.5%.  Every time there is a modest pullback you will see many warnings that this is the "big one."  That is when most investors bail out.
2. And of course there really are a few big ones.

Here is the helpful table via JP Morgan's Guide to the Markets:

The last couple of years have had unusually low intra-year declines. This might be giving a false impression.

Most investors are far too confident of their risk tolerance. I question new clients carefully on this front.  If you are going to have a portfolio that is 100% in stocks, no matter how diversified, you must be prepared to weather a 20% decline.  I ask clients to pick a number that would be an acceptable "paper" loss – and we all hate losses, even on paper.  If our own first-rate indicators said that it was a "psychological" correction, not supported by fundamentals, what number would be tolerable.  Take that number and multiply by 5. That tells you how much you can invest in stocks.

This approach works much better than some of the questionnaires used by various firms who are just touching the bases on compliance. I am trying to learn what people really think!

Most investors over-estimate their risk tolerance, take on positions that are too large, and then wind up selling whenever there is a correction. Their poor market timing is why they trail a buy-and-hold program by 5% or more.  The major reason for a bond portfolio is to reduce the overall volatility.

It is better to have an acceptably sized risk and stay in the market than to be too big and get scared out.

Every investor should start by considering risk, not return!

You should not try to be a poker-playing genius, going "all-in" or all out based upon some index, omen, or advice from a guru on TV. You need a low-volatility anchor for your portfolio. Traditionally, this has been the role of bonds.

The problem is that bond mutual funds are now too dangerous – likely losers as interest rates move higher.

Possible Solutions

In past posts I have covered this topic in some detail. Let us focus today on three possible solutions. (I continue to explore others).

1. A bond ladder. This allows you to get the interest rate you expect and principal on maturity. You can then roll out to the higher rates. The exit strategy is built into the program, unlike a bond mutual fund. You might only make 3% or so, but you can adjust to rising rates and it provides a conservative anchor to your portfolio, allowing you to step out with the rest.
2. Reasonable dividend stocks. I say "reasonable" because the quest for yield has driven some dividend plays into territory that is too rich for me. I do not like utilities, but I do favor some of the established companies with great balance sheets and dividends in the 3% range.
3. Selling calls against your dividend stocks. An actively managed portfolio, focused on selling the rapidly-decaying short term calls, can dramatically increase the return from a dividend stock portfolio. This is a good plan for those who are not seeking gangbuster market returns. It is safer and more dependable in a sideways market. It is a good blend for those who have a bond ladder and some stocks. I target 9% (after costs) but agile individual investors might match this or do better. You need a low cost broker.

There are other nominees under review. There are MLP's, but the tax issues dissuade many. There are alternative funds. There are structured products. Some of these ideas are very good and might be attractive for the average investor. The problem is the complexity and potential for a fatal mistake.

More to come on these ideas.

Conclusion and Anecdotes

The importance of right-sizing risk remains. The loss of bond funds as a solid portfolio anchor creates a new challenge.

I talk with many investors each week, both existing clients and those who might become part of our group. A recent case featured someone whose account had cratered during the 2008 decline. She now wanted to make it back in a short time, and asked me for a schedule of projected gains. This very smart person was focused on return, not on risk, despite her few remaining years until retirement. I'm not sure what the others promised, but creating false expectations is not wise.

Many others are very nervous. They read the headlines, which always sell fear (covered in this post where I explain how to quantify actual risks).

My basic solution is one that you can imitate. The Enhanced Yield approach serves as a bond substitute, reducing portfolio volatility while delivering 9% or so after commissions.  It will do this in a sideways market, and it also has a lot less risk than a stock fund in a declining market. Examples of stocks that you could use if you want to try this at home are CSCO, INTC, MSFT (old tech works well), KSS (surprising retail strength), and DE. The key is valuation, a reasonable dividend, and picking a call that is out of the money and will return 10% annualized from the sale. Do not chase if the conditions are not right.

Whatever you choose as an anchor, do not be over-confident about stocks. If you are young and willing to ignore volatility, the prospects are good. For most people, the risk/reward balance is crucial.

[Long all named stocks versus short calls]

Comments

[Anthony Leone]

I like your covered write suggestion. It is normally described as you've said 'conservative' and quite safe method of trading but the fallacy is it being outline as a boring grand dad type trade when in fact it can be quite powerful in capturing big gains on highly volatile stocks.

One example comes to mind TSLA Tesla back when it exploded in May I think Its options Implied Volatility stayed very high for months even though The company's earnings and growth numbers normally would have caused 'volatility crush' after these news items are released.

So on high growth stocks ( oh you can see the stock price climbed steadily from 40's to now 180 with no volatility)your returns are high with less risk since teh stock is rising what happens is your stock gets called away each option expiry now in the money buyer exercises stock away from you.

This is contrary to the limitations of your idea how this work stating it works well in sideways markets. yes but that is ideal only to teh extent you dont want your stock called away.

So really you do want it called away meaning you are in arising market( which to the undisciplined trader with no plan gets pissed he sees profits get away from him not the rational thinking he collected premium up from at a fixed amount instead of subjecting his pos to randomnenss)your position is safe.

Last thing you want is market to go down but as I say if you buy the top stocks with growth momentum. If e.g. you sold $2 call that is $2 downside projection so you have a b/e point.

being these can be volatile since option premium is high you still have many alternative strategies left as naked stock holder sweat it out.

First you dont get stopped out so you may just hold on till expiration as stock moves around.

If stock keeps moving down you can sell it or close out original options and sell a lower strikes in say October strike or look out at Novemeber if Implied volatility is near to thsi month sell the same strike( say now it lists for $180).

On a granddad stock like you mentioned dividend paying stock you can generate income no matter what market we're in as these people hold stuff for 40 years anyway by using this method of 'rolling down or rolling out to next month' you can see already what im getting at you are capturing volatility and turning it to your benefit.

Two things I see keep this method dormant is stock Brokerage industry describes it as you did in a very limited way and stock owners we know rarely devise a strategy and stick with it are too inflexible with thsi approach they want to collect premium but stay married to their crappy verizon stock.

As far as I can see its the only way to beat the market assuming a big bankroll of course and highly liquid option market.

[oldprof]

Pacioli -- It is interesting that your employer will not let you post any of your work (even things no longer relevant) but you are free to troll and comment during the work day.

Please email me about how others can get jobs like this. I get lots of inquiries.

As to the specific propositions, I trust that every reader can see how you have dropped the ball:

1) You did not respond to my specific link where I predicted the interest rate changes.

2) I write about recession odds every week, so the prediction is specific and frequent.

3) I write about financial stress every week, specific and frequent.

4) I give a specific investment forecast each week in multiple time frames. It is more visibility than anyone else....

5) You can check out my Europe link for those forecasts.

To summarize -- you have falsely portrayed what I have said. If you were a grad student, you would be getting the Gentlemen's "C" and quickly leaving the program.

I am delighted to have constructive comments where people offer interesting ideas. I am not really interested in people who are paid to nit-pick.

Either post something constructive or troll elsewhere..... (although I am somewhat flattered that your short-selling firm would think that I am worth the trouble!)

Jeff

[curmudgeonly troll]

If you're really a long-term investor (10+ years), the historical ERP has been so high and current bond yields are so low that it takes a rather irrational level of risk aversion to own bonds, unless you think the ERP is wrong and/or there's a substantial risk of deflation. The odds of stocks underperforming bonds over that time period are quite low and the average outperformance of stocks is quite high.

Basically agreeing with a useful post, bonds are not very promising, better to stick with stocks, yield instruments with equity-like returns, some cash for option value. Good time to remember that well-understood risk is your friend even if it results in some volatility, put on the right portfolio, understand risk level and why it makes sense to take it, and stick with it.

[Pacioli]

I wish that I could offer my substantive writings as an example of what I consider to be ample evidence supporting an assertion. Unfortunately, those writing are the property of my employer.

I am not trying to be nit-picky just for the sake of argument. Rather, in reading your posts over the years, you often make comments like the one in the above comments, along the lines of "Since I have been accurate on most current themes..."

In reading your work, I would say that you seldom, if ever, actually make specific predictions. Thus, it is confounding to repeatedly claim that you have been "accurate".

Regardless, I don't even think that specific predictions are the best way to assess investment opportunities. It makes more sense to just assess the various risks that abound, ask the right questions, and assign likely probabilities to various outcomes.

I like that your posts usually highlight the right themes to be looking at, and sometimes even highlight the right questions one should be asking.

I just tend to often disagree with the answers to the questions (if offered). And it is frustrating as a reader when a writer makes claims like "I have been accurate" when the writer hardly ever makes specific predictions in the first place.

I appreciate the limitations of what can be covered in a single post. But the impact of the words are maximized if specific, supported assertions are presented - as opposed to vague generalities. I guess it could be thought of as providing a "thesis" versus just a "theme".

[oldprof]

Pacioli -- You can only accomplish so much in a single post. I have various themes and an agenda that pieces them together, so I try to provide helpful links.

While I always publish your comments, they remind me of a grad student who is trying to poke holes in something without offering anything substantive. There is a nit-picking quality -- titles, you don't like my evidence, etc.

If you look at the entire body of my work, you will see that I define "real" market risks to be a recession (which hits earnings) and financial stress as measured by the SLFSI. I update both each week.

I warned about interest rates specifically in this post: http://oldprof.typepad.com/a_dash_of_insight/2012/06/the-quest-for-yield-part-7-what-about-bonds.html

You claim to have read the links, but apparently missed this one which is pretty specific, so I invite other readers to check your work:)

Meanwhile, how about providing a link to something you have written. You say that you usually disagree with me. Since I have been accurate on most current themes --the major political developments, on Europe, on recessions, on earnings growth, and on the market, as well as rising interest rates -- I would be very interested to see a comprehensive analysis of yours!

I welcome your comments, and readers can attach whatever value they believe is appropriate. For my part, I try to include at least one important insight in each post, usually something timely.

Thanks for joining in!

Jeff

[Pacioli]

Interesting thoughts in this entry.

I absolutely agree with the assertion that the most fundamentally important assessment each investor must make is determining the right level of risk.

A few comments on some of your other assertions:

"The problem is that bond mutual funds are now too dangerous – likely losers as interest rates move higher."

This is a loaded statement, which I think needs to be 'unloaded' carefully. First, the issue of mutual funds vs. other vehicles. I agree that bond mutual funds are an inferior option. I much prefer ETFs or closed-end funds (if trading below NAV). But perhaps those would even fall under what you are calling bond mutual funds. Regarding the second, more important, point: "as interest rates move higher" would seem to be a very strong assumption, entirely dismissing the possibility that rates may not go higher from here. Such an important assumption driving such an important allocation decision needs to be supported by stronger (any?) evidence, IMO.

"(covered in this post where I explain how to quantify actual risks)"

I followed the link over to read that entry in full. Unfortunately, the post does not explain anything about "how to quantify actual risks". I agree that it is of utmost importance for investors to quantify risk (much harder and much more important than quantifying return). So I was looking forward to some specifics when I clicked on the heading for this post. While this post covers assessing an investor's tolerance for negative returns, it does nothing to illuminate how to define and quantify risk. Perhaps the answer (reading between the lines) is that you simply define risk as downside return.

I suspect (and hope) this is not the case, due to your sophistication and experience. I think that readers would enjoy and benefit from a thoughtful post on how to actually define, quantify, and treat risk (not just what % downside can you tolerate).

[oldprof]

Joe -- You are right in noting that trading skill matters. I have possible trades teed up and ready to go, and we are constantly monitoring the opportunities. It is an advantage.

I have shared the kind of trade we do and provided some examples. It does require some patience.

It is a bit like household repair jobs. I don't mind trying some simple ones, but I call for the plumber or electrician if it gets too complicated:)

I guess it depends on the skill, interest, and patience of each person.

Interesting question ---

Jeff

[Joe Facer]

Hey Jeff, The way you as an investment pro with a lot of option experience plays the call-on-dividend-stocks vs the home trader/401 player, owes some degree of difference to your resources and experience. Given that investing for bond like returns leans hard on non volatility and forgoes the occasional lucky/ hard work big return to bail you out of bad luck and expenses, frictional costs can be substantial. Got any guesses on what it can cost the layman to do it himself vs you?