Portfolio Insurance

by: Russ Thornton

Some of my clients’ children have accounts set up with my firm. Among these accounts, there are a few exceptions.

Everyone else has part of their portfolio allocated to fixed income. This includes my personal portfolio.

I have no plans to change this approach or recommendation.

But with interest rates beginning to rise lately, we’ve seen the value of bonds go down. And that makes sense as bond prices move in the opposite direction of interest rates.

The fact that I utilize a fund of 7-10 year Treasury bonds, while increasing both the quality and liquidity of our fixed income allocation, doesn’t exempt us from the fact that bond prices fall as interest rates rise. Though 7-10 year Treasury bonds react much more mildly than many other bond and fixed income alternatives.

So it’s no surprise that some of you have asked recently about the bonds in your portfolio. Why do we have them? Why these bonds? Shouldn’t we move more to stocks since they’re going up right now?

I’d like to address a couple of these absolutely appropriate questions.

First, let me remind you of something I feel is important.

You shouldn’t take more investment risk than you need to in order to support your financial plan and your life.

In other words, if you can achieve your goals and the things that are important to you with less investment risk, why take more?

This isn’t based on age or occupation or even filling out a multiple-choice questionnaire about how much risk you can tolerate. Just because you can tolerate more pain (in the form of investment risk), doesn’t mean you should have to, does it?

So with that concept established, let’s get back to why bonds and why now?

When it comes to investment risk, statisticians typically measure it in terms of standard deviation, or how widely an investment varies around a median return.

Among the asset classes I use and recommend, cash has the least variability risk. This probably doesn’t surprise you.

Stocks have the most variability risk.

And bonds fall somewhere in between the two.

So to suggest we swap some bonds for more stocks because stocks are going up and bonds aren’t means we’d be taking on more risk as measured in portfolio variability. Volatility is another word that captures the essence of what I’m talking about here.

Further, to chase stocks as they’re rising can be hazardous to your wealth.

But let’s assume you’re OK with the level of stocks versus bonds in your portfolio and simply want to better understand why we hold the bonds in the first place.

My first explanation would be to say, “Diversification means always having to say you’re sorry.” Or in this case, it means I’m always having to say I’m sorry.

If you’re not adequately diversified, while it feels great to see your entire portfolio going up, research tells us that it feels twice as bad to see your entire portfolio going down as it does to see it go up. I’m trying to protect against the downside, and the high quality fixed income we use can be thought of as insurance against wild equity market swings.

Many people buy insurance in the hope they never need it.

Or at least they hope they won’t need it for many, many years.

Think of long-term care insurance or disability insurance.

As long as you’re healthy, you may occasionally question the benefit of carrying the insurance and paying the annual premiums.

But you’re sure to be happy to have it if/when you need it.

The same can be said of our approach to diversification using 7-10 Treasury bonds in your portfolio.

If the stock market’s going up, it’s natural to question why we own bonds, or why so much in bonds. But when the market goes down – and it can go down sharply with little-to-no warning – you’ll be glad you had some high quality fixed income in your account.

Bonds are typically seen as a “safe haven” in times of market volatility. And US Treasury bonds especially so.

History has shown us that these bonds are some of the best and least expensive “portfolio insurance” you can own to help offset the inevitable swings of the stock market.

You might also think of these bonds as “shock absorbers” to help smooth out the otherwise jarring effects the stock market delivers on occasion.

For anyone that knows me, I (along with many others) have been saying for years that interest rates will eventually go up. And here we are.

Will rates continue to rise? I don’t know.

But please remember that I’m here first and foremost to help you protect and preserve your accumulated wealth. Growth is important, but it’s secondary to preservation.

And for more perspective on this idea of portfolio insurance, please read this article from my buddy Sam Bass, written almost 2 years ago.