It’s often said during bull markets, “A rising tide lifts all boats.” When the markets are surging—and when the beating heart of our economy is strong and steady—most investors tend to benefit. To be clear, this adage doesn’t mean that the economic tide explains all movements of all assets, but rather that it provides environmental influence—a headwind or a tailwind, as it were—which makes performance easier, or more difficult. There will, of course, be a variance in how individual assets perform in any market.
There is, of course, a cautionary element here as well: it is a great reminder not to confuse environmental luck with personal skill. In other words, in times when everyone is winning, we’d do well to attribute this more to the market at large than our own unique, unparalleled skill. The latter—and the accompanying arrogance—will lead us only to trouble.
Turning the Tide
We are, all of us, at the mercy of those economic tides. And, sometimes, the opposite can also be true: a receding tide lowers all boats. On that note, enter: 2022.
…sometimes, the opposite can also be true: a receding tide lowers all boats. On that note, enter: 2022.
So far, this year has proven itself to be something of an anomaly. We find ourselves with the unique convergence of specific economic, social, and geopolitical factors. The highest levels of inflation we’ve seen in four decades. Interest rate increases by the Fed with no end in sight. Supply chain issues. Russia and Ukraine. COVID and Monkeypox. Johnny Depp and Amber Heard.
As a result, many investors find themselves with a portfolio that is entirely painted with red. And this applies nearly across the board: to riskier asset classes as well as safe, domestic as well as international, equities as well as fixed income, correlated, uncorrelated—
It seems to make no difference. Red.
For example, per Portfolio Visualizer, here is major asset class performance YTD (as of July 31, 2022):
- Total U.S. Market: 🔻14.05%
- S&P 500: 🔻12.65%
- International Developed ex-U.S.: 🔻15.00%
- Emerging Markets: 🔻15.60%
- 10-Year Treasury Bonds: 🔻7.91%
- Corporate Bonds: 🔻12.35%
- Total U.S. Bond Market: 🔻8.39%
- TIPS: 🔻4.92%
In fact, out of the 38 asset classes represented, only 2 have had positive returns YTD: cash and commodities.
As a result, the typical “flight to safety” we tend to see in times like these (investors fleeing the volatility of riskier asset classes, such as stocks, for “safer” asset classes, such as bonds) has failed to even get off the runway. After all, a flight to safety only works insofar as there is a safe place we can fly to. And if there isn’t…well, we’re all stuck sitting on the runway, sitting next to the loudmouth on a cellphone.
Many investors feel understandably cornered, and find themselves asking: Are we in new territory? Do the supposed “tried and true” methods of investing no longer apply? Are bonds still a ballast in a portfolio? Is the 60/40 portfolio dead (along with other variations of a stock/bond portfolio)?
Enter: a great article by Vanguard’s research arm. It’s well worth the time to read in full, but I wanted to pass along some key takeaways for me.
While periods of simultaneous stock and bond declines are not rare, the chances that they will continue together fall rapidly as we expand our time horizon. Vanguard notes: “Brief, simultaneous declines in stocks and bonds are not unusual, as our chart shows. Viewed monthly since early 1976, the nominal total returns of both U.S. stocks and investment-grade bonds have been negative nearly 15% of the time. That’s a month of joint declines every seven months or so, on average. Extend the time horizon, however, and joint declines have struck less frequently. Over the last 46 years, investors never encountered a three-year span of losses in both asset classes.”
All of this, of course, flies with the usual caveat: past performance doesn’t guarantee what will happen in the future. Might the future be different—might we see the traditional portfolio fall flat on its face? Sure, anything is possible. But, I think it even more likely that Vanguard is right when they note:
“Catchy phrases like the ‘death of 60/40’ are easy to remember, don’t require complex explanations, and may even seem to have a ring of truth in the difficult market environment we are in today. But such statements ignore basic facts of investing, focus on short-term performance, and create a dangerous disincentive for investors to remain disciplined about their long-term goals.”
Are Bonds Still Viable?
A lot of this current sentiment revolves around bonds—and specifically, how they appear to be withering under the twin dangers of rising interest rates and inflation. And so I think investors would do well to consider why, exactly, they hold bonds. For most, they serve the purpose of being an asset class diversifier and a portfolio stabilizer, and I suspect that despite current conditions, they will continue to perform these roles going forward. I see no compelling reasons that they won’t.
Even if you were to study them in an environment like this one—which is about as toxic for bonds as it comes—they are still somewhat cushioning the fall. Portfolios that include bonds have fallen, yes—but not fallen as far as all-equity portfolios.
I also think it’s worth remembering that there is a fundamental difference in holding our bonds inside funds as opposed to individual bonds. Bond funds are somewhat unique in that they not only allow for diversification across individual assets, but across time.
Bond funds are somewhat unique in that they not only allow for diversification across individual assets, but across time.
Here’s what I mean. If we were to purchase, say, a $10,000 bond issued by Company A with a 10-year term and a 3% coupon rate—that’s it. We’re committed to whatever the ravages of time (interest rates and inflation) do to it over our holding period. For example, in a rising interest rate environment with high inflation, this would mean not only watching the face value of the bond fall, but also the erosion of real value (due to high inflation) that we will recoup when the bond matures. That $10,000 will not have anywhere near the purchasing power it had when we bought it, and the coupon rate is not enough to make up the difference. Not good.
However, in holding our bonds inside bond funds, we have a built-in tailwind in times of rising interest rates due to the structure of funds. The fact that we are diversifying across bonds of different issues and terms means that bonds will be continually maturing inside the fund, and repurchased at higher coupon rates. This will help us keep pace with the changing conditions that individual bonds would struggle against.
The strength of this tailwind, however, depends largely on the terms of the bonds held within the fund. This means that investors would do well to evaluate their time horizon against the average duration of their bond holdings—and ensure, if possible, that the former exceeds the latter. Short-term pain, but long-term gain.
Suffice to say that there has ever been a push and pull for investors’ attention between the short-term noise of the market and long-term fundamentals. This is especially true in times of volatility. But I also think that during these times, the discipline to stay the course and hold to a plan based on solid fundamentals holds even greater weight.
Vanguard, meanwhile, manages to convey this sentiment in much more poetic terms: “But the 60/40 portfolio and its variations are not dead. Like the phoenix, the immortal bird of Greek mythology that regenerates from the ashes of its predecessor, the balanced portfolio will be reborn from the ashes of this market and continue rewarding those investors with the patience and discipline to stick with it.”