Bond bears are right — and wrong
Reprinted courtesy of MarketWatch.com
Published: Oct. 8, 2014
To read the original article click here
People learned a long time ago that it’s a lot easier to control a horse if the animal is wearing blinders. Think about it: The horse “knows” what he sees, and he sees only what’s right in front of him.
That horse’s visual universe has shrunk — conveniently for his handler, but sometimes at the expense of the animal.
I thought about this last weekend in connection with the many investors today whose vision is focused tightly on bonds — and on the notion that they’re going to lose money when interest rates go up.
I call these people the bond bears. They are right that interest rates are likely to go up. They have to. And they are right that this will depress the prices of existing bonds.
But the bond bears are wrong if they think this means they should sell their bonds or avoid the category. Collectively, investors who don’t get this figured out are likely to lose billions of dollars — losses that are totally unnecessary.
I can’t tell you when that will happen, but I’m sure it will, as I discussed in my previous MarketWatch.com column.
Bond bears have plenty of reason to believe they’re right. Who could be a better expert than Bill Gross, the man who for many years ran the world’s biggest bond fund?
I found a Fortune magazine headline that quotes Gross as saying “bonds could be in for a world of hurt …” because of the inevitable rise of yields and concomitant fall of prices.
There’s just one little problem: That dire warning of impending doom was made in the spring of 2011, and the big plunge has yet to happen.
Bill Gross put his money (actually his shareholders’ money) where his mouth was and reduced the Pimco Total Return Fund’s PTTAX, +0.10% stake in U.S. government bonds to zero that year.
At the same time, he more than quadrupled the fund’s stake in cash. (If you have a bank account that pays 0.03% annual interest, you will understand the implications of that move.)
Bill Gross isn’t the only bond expert who has been flummoxed by interest rate predictions. The previous summer, in August 2010, Morgan Stanley issued a huge mea cupla for incorrectly forecasting that interest rates were about to rise.
“We got our rates call wrong and missed a great opportunity” to own bonds in 2010, the firm’s clients were told by James Caron, head of U.S. interest-rate strategy at Morgan Stanley in New York.
Someday these fears will come true, just as someday the stock market will take another serious dive, leaving millions of investors stunned and outraged to discover that such a shocking thing could happen.
Recently I received a message from a reader who believes the bond market is “in a weird short-term situation” in which it is failing to live up to his expectations.
This investor has liquidated his 40% stake in bonds (which, if chosen correctly, are paying a rate above inflation) and put that money in cash, which he admits pays him zero.
“I would normally hold bonds but feel they will be going down in the next couple of years,” he wrote. “I plan on staying in stocks no matter what.”
Those last three words — “no matter what” — send a chill up my spine.
It won’t surprise me a bit, sometime in the middle to late stages of a bear market, to get a message something like this from a reader: “I’m just too worried about further declines in stocks right now, and I’m going to cash. I plan on staying in bonds no matter what.”
The problem here isn’t bonds. It is not the bond market, or the Fed. It is not the stock market. All those entities are doing what they normally do.
No, the problem is individual investors who are trying to discern the short-term future of the markets and answer the question: What should I do about this?
I don’t think there is a “right” answer to that question — because it’s the wrong question. If you keep asking the wrong question, any answer you will get won’t be right.
The right question is what is the best way to allocate your assets for the long term, based on lots of historical data. (If your time horizon is too short for “long-term” to be meaningful, then you should probably have most of your portfolio in money-market funds and short-term bonds.)
I stress the need for historical data because, as we have seen, subjective assessments are just not reliable, even when they’re backed by all the research capacity of Wall Street.
Over many years of working with thousands of investors, I’ve learned that a disciplined mechanical approach, combined with a lot of patience, will always trump short-term subjective assessments and emotion-based actions.
In fact, this is one of the most important, game-changing decisions that investors make.
Today’s bond bears, like all investors who try to anticipate the market’s moves and adjust their investments accordingly, can never know what to do. The result is often anxiety, lost sleep and decisions that turn out to be unfortunate and counterproductive.
Wall Street, by the way, thinks this is just fine. The securities industry’s favorite client is someone who’s always on the hunt for a way to do better. This creates transactions, and transactions create income for securities firms. (For me, it would create heartburn.)
Fortunately, there’s a better way: Use a mechanical strategy. That’s what I do with my family’s money.
About half of my portfolio is divided 50/50 between equity funds and bonds, and the only “timing” involved is to periodically rebalance the account.
This gives me enough equity exposure to achieve “a piece of the action” from rising stock market periods. And the 50% stake in bonds provides a comfortable cushion when stocks are faring poorly.
The rest of my portfolio is governed by a timing strategy that moves assets back and forth between bonds and cash, and between stocks and cash. These moves are based on mechanical timing systems that don’t rely on human decisions, judgments or forecasts.
I’ve been relying on this mechanical, trend-following timing strategy for many years; it has reduced my risk and improved my peace of mind. This works only because I never second-guess the systems.
This portfolio makeup is the result of many hours of study, thought and discussion. Once I determined that I had the right overall strategy, I set it in motion and let my adviser (yes, I have one) carry out my wishes.
This is easy for me because I trust my overall plan and my systems for implementing it. And it’s easy for my adviser, because I don’t require him to “be right” about what’s coming up in the market.
The long-term returns of these two halves of my portfolio have been virtually identical. In some years, timing outperforms buy-and-hold, and vice versa. That’s fine with me.
I also like the massive diversification that comes from having positions in more than 12,000 stocks in my buy-and-hold portfolio and (when fully invested) about 5,000 stocks in my timing portfolio.
The mechanistic approach I use is what I recommend. But I know it isn’t easy for most investors, exposed as they are to the constant commentary of today’s financial media.
There are so many things to worry about: How does my portfolio react to Ebola? Global warming? The Republicans? The Democrats? Obamacare? The Supreme Court? The Federal Reserve? How about the hundreds of other important variables that will influence the market?
Those questions could haunt me endlessly if I let them. Fortunately, I have discovered what I regard as the answer that’s right for me: Leave those worries up to the market.
The stock market adjusts security prices millions of times every day as eager fingers frantically punch computer keyboards trying to get an edge on the markets. There’s no way I can compete with all that — and I have no need to.
Whatever’s happening in the world will immediately be “built-in” to stock and bond prices before I ever hear about it. This is good news because it lets me live my life without constant worry.
Today’s bond bears would be better off if they took a similar mechanical approach.
Richard Buck contributed to this article.
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