Hope Is Not An Investment Strategy

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The Greek philosopher Aristotle (384–322 BC) famously proclaimed “Hope is a waking dream.” Perhaps wisely so, he did not specify what sort of dream. Nightmare is the likely outcome when misplaced hope in flawed investment concepts is all there is to the foundation of future financial goals.

 

The traditional model of generating investment returns and controlling risk failed catastrophically in the 2008/09 financial crisis. Yet, surprisingly little has changed since. The vast majority of financial folk out there are still applying the same flawed investment concepts. Our profession has mostly ignored an opportunity to learn and improve.

 

The problem is easily demonstrated through a health insurance analogy: Of what use is a health insurance policy that covers one broken toe (or mild stress on the financial system) but may or may not cover two broken arms and two broken legs (or high stress on the financial system)? The very idea of insurance is to protect against disaster, else we might as well not spend money on insurance in the first place.

 

If you don’t work in finance you might find it surprising to learn that most investment portfolios are still being designed based on the “one broken toe” approach. Meaning, investment portfolios are reasonably well–protected against smaller mishaps in financial markets but did and likely will catastrophically fail again under severe adverse conditions.

 

The root problem of the “one broken toe” model is the traditional allocation of investment capital to stocks and corporate bonds: The hope part of the model is that less volatile corporate bonds act as a hedge for more volatile stocks. This can be both, true and false. It is somewhat true under mild financial stress but quickly becomes false under severe financial stress. In the latter scenario, stocks and corporate bonds nose-dive more or less simultaneously, although at different rates.

 

The relationship between equities and corporate bonds seems almost as complex as the relationship between men and women, famously described in the best seller “Men are from Mars, Women are from Venus.”

pst_stock and corporate bond correlation

The most irritating part of that Mars-Venus relationship between stocks and bonds is its ever-changing nature, as depicted in the graph above. The traditional “one broken toe” approach ignores those more complex dynamics and assumes a stable relationship along the lines of the “Average correlation” line in the chart above. Hoping that the actual relationship (blue bar) matches up with the average (gray line) puts investor into the camp of making hope instead of facts the foundation of their investment portfolio.

 

We believe in common sense solutions to the problem: Severe financial stress always coincides with a rise in market volatility. Thus, why not use volatility as a much more reliable hedge to combat portfolio risk? In fact, for almost a decade volatility has been liquidly traded. It can be bought and sold just like IBM stock.

 

The main reason why this concept hasn’t found a widespread following beyond more hardcore professionals in major financial centers is likely the fact that it has only been around for about a decade. For many more decades, however, investors have been told stock and corporate bond portfolios are well diversified. Therefore, it might simply be asking too much to adapt to new facts within just a decade. After all, our wise friend Aristotle argued more than two thousand years ago that the Earth must be a sphere; it took everyone else only a few hundred years to catch up to that fact.

 

Just to clarify – we are not predicting another financial meltdown for tomorrow, although such “Black Swan” events can never be ruled out. The issue at hand is this: For investors who care not just about maximizing return but also about minimizing risk, the “one broken toe” model of managing portfolio risk is both a waste of money and dangerous: A waste of money because –on average- corporate bonds return less than stocks. Dangerous because corporate bonds have failed to diversify when diversification is needed the most: under severe adverse conditions.

 

At time of writing, U.S. equity markets have just made a new all-time high. Of what value are such all-time highs if we don’t actually get to keep as much of those gains as possible through effective risk management?

 

In case you want to find out if you have been dealt one of those “one broken toe” time bomb investment portfolios, there is a way to do so in an unbiased way: The independent firm Hidden Levers specializes in stress-testing investment portfolios to uncover both strengths and weaknesses across a wide range of past and possible future market scenarios.

 

Contact us here if you would like us to cover Hidden Levers’ fee to rigorously stress test your current investment portfolio. We do this because our Smart Wealth portfolios hold up well both when the sun is out and when it rains. Your investment portfolio should do the same.

 

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