Ballast

Over the past few years we’ve been periodically asked by clients why, if stock returns are so good, that we don’t put even more stocks into your unique portfolio.  Given the high equity returns in 2012 and 2013, the question has come up a few times so we’re going to address it here.

You have a portfolio created to do one key thing in mind; invest with a goal-based (outcome based) financial plan in mind to achieve the long-term returns needed WITHOUT taking more risk than is necessary.  Frankly, that is hard to do.  What is easy to do is to construct a portfolio that might have higher returns.  However, as soon as that is done, almost as a tautology you add more risk to the portfolio.  As said in previous communications, we all like volatility on the UP SIDE, but we abhor it on the down.  Therefore, if your most important goals can be achieved without losing unnecessary sleep and incurring greater risk / volatility, then it would be illogical (or greedy) to do it.  The market declines over the past days and weeks is examples of that volatility, and only a masochist would feel good about them.

So what do bonds do?  What is the purpose of fixed income in your portfolio?  Without a lengthy dissertation, they serve three valuable purposes;

1. By their very nature, bond prices move in different ways (if not different directions) than stock prices do.  Avoiding statistical jargon like covariance and correlation effects, let me just say they are a strong diversification move.
2. They do contribute cash flow into a portfolio.  This allows some return / income in a portfolio to be more dependable as all bonds have a stated interest rate or methodology (called coupon rate) and companies are subjected to legal requirements to pay it.  Equities have no legal documents governing their ‘return’ as even dividend policies can and are changed.
3. Perhaps underappreciated is the stabilizing nature of high quality / short term bonds in your portfolio.  Therefore, this statement is more specific to Wellspring because of how we do things.  Bonds come in all varieties and can be low quality / long term in maturity as well.  In fact, many bonds over the last 5-10 years that have been purchased are of this later variety because they have exhibited strong returns as interest rates were low and going lower.  However, those types of bonds have been hard hit by the mid-summer 2013 announcement of pending ‘tapering’ by the Federal Reserve and declined by 5-12%[i].  There were declines in some of the bond funds here, but all resulted in the range of 0.4-2.9% for 2013[ii].

As an example of the above points, 3 out of the 4 bond funds used in your portfolio have shown a positive return in 2014[iii] while the market has headed south.  We’re not a soothsayer of returns, but let’s say the domestic and global stock markets stay down in 2014.  Nobody wants negative equity returns, but what is good for the goose is good for the gander.  Should that equity decline be reality, two positive steps will be witnessed in your portfolio.

1. Your portfolio will not go down as much as the equity declines that you hear about because you have the bonds in your portfolio.  They are ballast to your financial ship, and no good ship runs without ballast.
2. Given that the bonds will stay up in value, or certainly up ‘relatively’ to the stock’s decline for the reasons mentioned above, an opportunity presents itself.  We target the asset allocation for your account to be a certain number (i.e. 50 / 50).  This regiment keeps one from being too greedy, but it also prevents against panic.  The bonds represent a store of ‘dry powder’ in a rain, the rain in this case being the decline in equity prices.  Staying with the regimen we have established, when the time is right you will use your dry powder to purchase stocks when others are fleeing them (thus, panic), thereby buying them when they are down in price.  Stocks commonly bounce back in the 9 – 18 months’ timeframe (and these are bear market numbers, not simple corrections) and your low purchase price stocks now take the ride to higher territory and you have attractive returns once again.

The dispositive value of bonds working in conjunction with equities is what makes this work.  If you have no bonds, you’re just a one–handed juggler in a high wind and life becomes a whole lot tougher.

A net effect of all the above on your portfolio is somewhat muted returns when times are spicy, but you also have less downside when troubling waters hit.  I’ve never been in the Navy, but having owned and skippered sailboats I can tell you that the value of ballast is vastly underappreciated until you need it in a stiff wind.  With it, you remain in control, and you definitely feel it emotionally and physically.

Here’s to ballast and an in-control ride.

[i] 2013 Bond Market Performance: The Year In Review (Thomas Kenny, About.com Bonds)

[ii] Dimensional Fund Center December 31, 2013 for the Five Year Global Fixed Bond, Short-Term Extended Quality Bond, Selectively Hedged Global Fixed Portfolio, and Investment Grade Portfolio.

[iii] Ibid.  Performance Data Year-to-Date through February 3, 2014