How to Diversify in current climate

MaxiRobriguez

For the bond rally to continue it requires interest rates to continue falling. I suspect the base case for bond returns in the short-medium term is pretty much flat (but there is a risk bonds suffer a bear market if there's a pick up in inflation which is matched by central bank policy.)

For the same reason I think the returns for equities (in the US market) is roughly flat. Multiples are high but debt is cheap, and some of the biggest names pay a better dividend than you can get in bonds. There's enough protection their against things which aren't an outright crisis.

Europe, UK and EM equities are different, UK especially. Some of the multiples in companies which have decent balance sheets and aren't in industries at risk of being revolutionised are at generational lows.

If you're wanting to preserve capital then I think a global index tracker is going to give you a nice mix of solid but expensive US, cheap growth potential in EM and dirt cheap dividend payers in the UK. Wrap that around a small allocation to bonds and branch out if you want to have a small holding of gold or cash which you can use as dry powder and I suspect you'll be fine.

I suspect the worst move people could do at the moment is increase bond allocations, especially if they're not buying an annuity at retirement.

DairyQueen

GBY wrote: »

I’ve been looking to reduce my exposure to equities within my DC company pension as retirement should be between 15 to 20 years away. Much of my research has been on this site, Monevator and reading the books by Tim Hale and Lars Kroijer, over-simplified summary would be world tracker for growth and bonds/gilts for defence/conservation in variable proportions, perhaps some REIT thrown in.

Your investment horizon is quite long to de-risk in preparation for retirement. Typically, positioning a portfolio for retirement takes place around 5/10 years prior.

With your timescale I would seek to de-risk only if your current equity allocation is too high for your overall tolerance to risk. The tone of your post suggests that this may be the cause of your concern.

GBY wrote: »

That’s all well and good but bonds and gilts have been unnatractive in recent times and have a pessimistic outlook, according to what I've read.

QE has impacted the pricing of bonds across the spectrum. In decades prior to the financial crisis bond prices were inversely correlated to equities so generally prices rose as equities fell ('flight to safety'). That link has been lost but bonds have more than one function. They provide a necessary counterweight to equity volatility for those who are unwilling/unable to experience a potential 50%-ish drop in the value of their portfolio for months/years. I presume that this kind of drop would keep you awake at night regardless of the timescale and extent of an equity recovery?

Fixed interest is a diverse asset class. It includes assets across the risk spectrum from low-risk government bonds issued by developed economies, through higher risk (ditto of developing economies), through 'investment-grade' corporate bonds issued by large companies, through highly risky 'junk' bonds issued by companies and governments considered fiscally unsound.

As with all investments, the potential reward is relative to the risk. Some government bonds are now priced such that the returns may be negligible to zero. However, they will stabilise the volatility of a portfolio and limit the downside of equity falls.

Income-driven investors are less interested in the volatility of a bond's price than in its coupon yield at the point of investment. Bonds still hold an important place in their portfolios.

GBY wrote: »

Staying overweight in a world tracker is not desirable if there is a correction or crash with only 15-20 years to go.

History suggests that there will be several of the former and and at least one of the latter over this timescale. However, history also suggests that equities will generally increase above average inflation over that period so being invested in a global equity tracker is unlikely to lose you money. Being 'equity overweight' is defined by your personal aims, investment timescale and tolerance to the inevitable interim corrections/crashes.

GBY wrote: »

I want to keep life simple but the choices don’t seem to be as clear cut as when these books were written and it’s hard to decide upon a suitable mix for growth and preservation should any downturn last a long period.

QE has muddied the waters for all savers/investors. It has especially muddied the waters for those leading-up to retirement. That isn't you. You will be drip-feeding your portfolio for many years so will benefit from pound-cost averaging when markets drop. Nobody knows what will happen next year let alone in 15 years. You have plenty of time to ride-out the vagaries of the equity and bond markets.

Firstly you may wish to consider your tolerance to market volatility. Would you sleep well if your portfolio dropped by 20-30% with over a decade left to recover? If so, aim for 50/60% equities. If no, then reduce the equity allocation. Having said that, anything below 40% equities is unlikely to facilitate a recovery in your portfolio within a decade of a market crash.

Also be aware that QE, and/or its aftermath, may persist for a decade or more. If so, equities will need to do some heavy lifting to compensate for the impact of QE on bonds. That's one argument in support of a higher %age in equities over a 10+ year timeframe.

GBY wrote: »

I wonder how many others are struggling to find a comfortable balance.

With a timescale of 15+ years I would ignore the quirks in the bond market and rebalance based only on my tolerance to risk. Choose a global bond fund that is highly diversified across regions and maintains a high percentage of investment grade bonds.

The return on the fixed interest %age of your portfolio may be low but it's still a price worth paying to reduce volatility. Your pension will also benefit from the uplift courtesy of the taxman and that will go some way to reducing the impact of inflation.

One of the drawbacks of pension wrappers is their failure to provide anything close to a retail rate of interest on cash. Holding cash in a pension wrapper over the long term is therefore a guarantee of a substantial loss courtesy of inflation. A highly-diversified, cheap bond tracker is therefore likely to beat pension-wrapped cash. Add in a smidge of gold and/or property if you wish to further diversify the non-equity allocation.

Those of us closer to, or in, retirement are more at risk from the impact of QE on bond prices. But (if age 55+) we also have the option to access our pensions and hold a larger %age in cash at retail rates. This, of course, has downsides (exposure to IHT, income tax, inflation, MPAA, etc.) but for cash required for drawdown in <5 years individual circumstances may mitigate the risks of holding a larger than usually advised cash allocation.

I agree with Maxi up to a point. Those approaching, or in, drawdown have decisions to make about strategies that were designed around a different type of bond market than currently prevails. I have chosen not to increase allocation to bonds for the foreseeable despite OH retiring in 18 months. We now hold sufficient cash to meet our drawdown needs for the next 5/6 years and to suspend drawdown completely for 3 years after that. Some of the cash is pension-wrapped at a negligible interest rate but inflation risk over a relatively short period is a lesser concern for us than more exposure to the bond market over the same relatively short period.

Our risk tolerance is high by UK standards so I am holding 40% bonds in the part of my portfolio that will be in drawdown in 5-10 years and 20% for 10+years. The 15+ year timescale is 100% equities. OH's portfolio is more aggressive as , in 6+ years, drawdown will be optional for him and unlikely to be more than 2/3% regardless.

So, yes, for some people buying bonds now may not be the best idea but for many others they still perform an important function. For those, like you, with decades to retirement, I wouldn't fret too much. Adjust your asset allocation based around your risk tolerance, choose low cost funds, keep it simple with trackers, lock-up-and-leave.

Thrugelmir

SonOf wrote: »

Have they? Whilst high yield bonds and corporate bonds are not overly attractive, gilts haven't been at all bad.

The iceberg being the yield to maturity. Not the current market value. Capital gains have inflated short term fund performance.

There's only been 6 new corporate bond issues on the LSE since the beginning of 2018. Companies have little need of tapping the markets for cash currently.

Linton

Thrugelmir wrote: »

The iceberg being the yield to maturity. Not the current market value. Capital gains have inflated short term fund performance.

Exactly. Safe bond prices cannot continue rising at the rates of recent years much longer before their yield to maturity becomes negative. At that point why would anyone buy them apart from it perhaps being cheaper for large institutiopns to lose money on bonds than pay the bank charges for holding large amounts of cash?


The increase in bond prices is not why someone should buy safe bonds. They are supposed to provide a steady ongoing return based on income, not on capital gain. They are therefore failing to meet their primary objective in a small investor portfolio so I find it difficult to see why anyone should recommend them. Safer to simply keep the money one doesnt want to invest in equity as cash.

There's only been 6 new corporate bond issues on the LSE since the beginning of 2018. Companies have little need of tapping the markets for cash currently.

There is a whole world out there.

bostonerimus

As you have time on your side stay invested in what has historically been an appropriate asset allocation, that might be a 60/40 diverse equity to bond allocation (bonds would be both government and corporate of intermediate duration).

If you want to back that up with a strategy that is guaranteed to give you good return then look into reducing what you spend. That will get you a 100% return. I'm not being funny, people often miss the simplest and most direct way to increase their net worth and that is simply to not spend as much.

bd10

Equities used to be inversely correlated to bonds. Thanks to QE, that's no longer the case. This has direct implications when the next equities sell-off will occur. My personal working assumption is that both will remain correlated in a down-turn as well. Sovereign bonds may hold up better in a crash scenario but my biggest concern is high yield and corporate debt. That is a bubble I fear will implode. The lower the credit quality of a corporate or high yield, the more they behave like equities. If this bubble deflates, this would be similar to the credit crisis of securitized debt 10 years back. Stocks would get sold off too in this scenario. So, what's the hedge? Maybe gold, Yen, short ETFs on indices. Treasuries? Only if they will be considered safe heaven this time again. (But I am putting a question mark behind this as this time the bubble is also massive in the whole bond market) That's my theory. Impossible to time, so many grey or black swans to could trigger it.

How to diversify at the moment? I am sporadically buying / hold individual shares or investment trusts I fancy and only if they trend up, if not, no game. From open ended funds I stay away as I want liquidity and if things get hairy, I want to be able to buy and sell immediately not having to wait for closing prices or worse, getting shut out from redemption. (As note on the side: high yield open ended corp. bond funds are seriously dangerous in my opinion. IMF had a paper the other week. Over half of European issuers could not meet redemption if stress tested). Rest in money market, if bonds, only as ETF on AAA rated sovereign titles, no high yield, no corporates. My focus is now on capital preservation and not aggressive growth. Market conditions are too unstable at the moment to be long 100% equities (what I would normally do). When there is more macro/global clarity on affairs, equities are game again.

in_and_out

There may well be pitfalls in high-yield bonds. But that's a small part of the total bond market. And high-yield bonds have always tended to be positively correlated with equities. That's never been how to stabilize/diversify an equities-heavy portfolio.

Gilts have been the main way to do it (for a UK investor), and they still work. The exact correlations vary, but they still tend to rise when equities are falling sharply. And they are also much less volatile than equities.

Investment-grade corporate bonds are less effective as ballast, but holding some does not have to be very risky. In a sense, the main risk is that they may be downgraded to high-yield.

If you prefer to skip corporates, and stick to gilts and cash for ballast, that's a valid approach.

But as for ... "Maybe gold, Yen, short ETFs on indices" ... exotic investments are not going to help in a search for stability.

"I am sporadically buying / hold individual shares or investment trusts I fancy and only if they trend up, if not, no game" ... is rather off-topic. You may have your reasons for getting your equities exposure via individual companies (though I wouldn't recommend most people to do that), but that will make your equities less diversified, not more.

You may have your reasons for making your portfolio complicated, but there is no need for other people to do so, under the misapprehension that the standard methods for diversifying have ceased working.

itwasntme001

bd10 wrote: »

Equities used to be inversely correlated to bonds. Thanks to QE, that's no longer the case. This has direct implications when the next equities sell-off will occur.

This statement is factually incorrect. The correlation between bond prices and stock prices depends on the period you are looking at:

1930s/1940s: +ve correlation between stocks and bonds (prices)
1950s/1960s: -ve correlation between stocks and bonds (prices)
1970s/1980s/1990s: +ve correlation between stocks and bonds (prices)
2000s: -ve correlation between stocks and bonds (prices)
2010s: +ve correlation between stocks and bonds (prices)

The size of the correlations varied from year to year and period to period. But there is certainly nothing that suggests that it has been negative throughout history and that the recent +ve correlation is a new phenomenon.

It is anyone's guess when the correlation will flip back to negative, but given history we know that time is coming sooner and sooner everyday. The question is will it be bonds that will fall or equities (by definition it has to be one or the other under a -ve correlation period). And could we see both fall first (under current +ve correlation period).

Keep in mind that inflation not only hurts bonds, but can hurt stocks pretty badly too. Maybe it will be an inflation scare (resulting in the FED forced to tighten) that could cause bonds and stocks to fall hard.

Or maybe we can continue this low inflation era, that we all are so used to, a bit longer. I know one thing is for certain - never ever think in the long run it will be ok with 100% certainty because there's a reasonable possibility at today's asset values that the returns could be negative even in 10 or 20 years from now (even with a 100% equities portfolio).

bd10

itwasntme001 wrote: »

This statement is factually incorrect. The correlation between bond prices and stock prices depends on the period you are looking at:

1930s/1940s: +ve correlation between stocks and bonds (prices)
1950s/1960s: -ve correlation between stocks and bonds (prices)
1970s/1980s/1990s: +ve correlation between stocks and bonds (prices)
2000s: -ve correlation between stocks and bonds (prices)
2010s: +ve correlation between stocks and bonds (prices)

The size of the correlations varied from year to year and period to period. But there is certainly nothing that suggests that it has been negative throughout history and that the recent +ve correlation is a new phenomenon.

It is anyone's guess when the correlation will flip back to negative, but given history we know that time is coming sooner and sooner everyday. The question is will it be bonds that will fall or equities (by definition it has to be one or the other under a -ve correlation period). And could we see both fall first (under current +ve correlation period).

Keep in mind that inflation not only hurts bonds, but can hurt stocks pretty badly too. Maybe it will be an inflation scare (resulting in the FED forced to tighten) that could cause bonds and stocks to fall hard.

Or maybe we can continue this low inflation era, that we all are so used to, a bit longer. I know one thing is for certain - never ever think in the long run it will be ok with 100% certainty because there's a reasonable possibility at today's asset values that the returns could be negative even in 10 or 20 years from now (even with a 100% equities portfolio).

I should have been clearer, the bond/equity correlations I looked at are during periods of equity market crashes. I took the past 8 most significant ones starting with 1987. This was not a long term study. That's why I also calculated the returns for other safe haven assets which can be bought via ETFs, again only for hedging purposes. Long term is a different ball game

itwasntme001

It is a very tough one. Probably now is the toughest ever time to be an investor. My feeling is we get continued low inflation with growth scares in the medium term which means bonds should perform well even still relative to equities. Some are even calling for 10yr treasury to fall towards 1%. It is not hard to imagine this as being a real possibility.

It may also be wise to hold a decent amount in cash to take advantage of corrections.