This post originally appeared on Forbes.com.
Before you dump bonds, remember why you have them.” So says the mainstream financial press, echoing countless advisors. Their big point is that investors shouldn’t get too spooked by the recent carnage because bonds have, for decades, acted a ballast against stock volatility, and that sort of insurance will certainly be necessary again.
But they’re making one huge mistake: thinking that bonds are still the best way to get that protection. It’s really pretty simple: if the 30 year bull run in the bond market is finally winding down, then so is its capacity to absorb stock market shocks. There is no magic, or logic, or history, that says otherwise.
The misimpression that bonds always cushion stock shocks has, of course, been stoked over the past decade, when 85% of bond profits have came from price appreciation, not coupon income. Those massive (but unrepeatable) gains did indeed save numerous 60/40 portfolios from grievous damage. But the past is the past.
Bond yields have been as low as they are today only about 4% of the time that government bonds have existed. If they keep moving back towards historical rates (not in a straight line, of course, but in fits and starts), they will keep losing money: on average, for each 1% rise in rates, a 10 year bond will lose 10% of its value. And things that lose money don’t cushion the blow from other things that lose money.
As readers of this column know, The Alternative Answer argued, on its release in mid-May, that investors should exit bonds immediately. Of course, the precision of that timing was accidental, but the advise was based on the logic that the odds were strongly against a continuing bond rally, and the damage that would be caused by a reversal was too great to suffer the risk. The book provides numerous, safer options for generating current income (see www.altanswer.com).
But today we’re focused on a different point. Should investors stick with bonds, despite the potential for more losses, because they can balance out stock market volatility?
No doubt, that is a crucial function. The number one key to long term wealth accretion is: don’t lose what you already have. It’s not so important to outperform the stock market on the upside; but it’s very important to outperform it on the downside.
So the real question is, what’s the best way to do that today, considering the risk and expense of the options?
One solid choice is a basic long/short mutual fund. These have been described in previous columns (and the book), but the one-liner is that they hedge against stock market dips by holding short positions against their long book– a form of insurance. Now please note that these will, necessarily, lag the market when it’s heading straight up; but should very significantly outperform it during down periods (and, yes, more are coming).
When shopping for these sorts of funds, note that some run the strategy internally, while others allocate funds outside to experienced managers. The later variety is attractive because you get manager diversity along with the strategy diversity. But pay attention to total fees (there’s a big difference between funds on this point) and to the experience of the managers: a few famous labels have jumped into this pool without the proven managers I’d prefer to see.
Of course, a totally different way of putting shock absorbers into your portfolio is to diversify into other asset classes. Real estate is perhaps the most obvious choice here, but be careful. If you’re investing in the sector to achieve non-correlated returns, you don’t want to be overly exposed to subcategories, like residential housing, that are highly dependent on leverage (the main culprit causing most real estate to sell off with stocks in the last crash).
So here’s one out-of-the-box idea: farmland. Despite the recent price run-ups, the fundamentals here are very strong: as the world’s middle classes grow and gain political might, they demand more protein and meat; and there are a constantly shrinking number of acres from which those can come. At the same time, new seed and irrigation technologies — are improving yields of many crops so that income levels (and values) can rise. Crop insurance, geographic diversification, and the right sorts of contracts with the producing farmers protect smart farmland investment managers from most of the obvious risks.
Admittedly, farmland is not the easiest asset in which to invest (related ETFs actually invest in agricultural companies, not at all the same thing). But many well-managed private investment funds do operate in the category, and many have smaller investment minimums (some as low as $50,000), with shorter lockups, than typical private equity funds.
Returning to the main point: there are great options for balancing out stock market volatility; and therefore there’s no need to rely on an asset class for that job that itself faces huge challenges over the next few years.