This article was published more than 3 years ago. Some information in it may no longer be current.
The only free lunch on Wall Street is diversification.
Putting assets in your portfolio that can help reduce your risk is the prudent thing to do.
For 15 years, analysts and strategists have been telling you to be bearish on bonds - that prices would fall and yields would rise. Until the election of Donald Trump, the reality is long-term bonds have outperformed stocks for the past decade.
While that suggests the best of the bond market rally may be behind us, the same could be said for the equity market rally, given lofty valuations.
From a yield perspective, long U.S. treasuries (TLT-Q) yield about 2.8 per cent and long Canadian treasuries yield about 2.0 per cent (ZFL-T). This compares to a yield of less than 2 per cent for the U.S. equity (ZUE-T) market and a 2.7-per-cent yield for the S&P TSX (ZCN-T).
From that perspective, the U.S. bond market is more attractive than the Canadian market. The Canadian equity market is more attractive than the U.S. market, especially in a taxable account where the dividend tax credit offers a better after-tax return.
Currently, a 5 basis point move in 30-year U.S. bonds is equal to $1 in price or about 1 per cent. Because the interest rate coupon on the long Canada bond is lower, about 4 basis points is equal to $1 in price. If U.S. long bond rates fall 25 basis points, that's a price gain of 5 per cent. Looking at market history, that could easily happen if the stock market falls 5 to 10 per cent . U.S. long bonds found yield support around 3.20 per cent in December and March, and would need to make a clean break above that for a more bearish scenario to play out. Despite the Federal Reserve's desire to raise short-term rates in 2017 and 2018, the bond market is beginning to suggest that may cause a recession.
Historically, from a risk perspective, long bonds (with a maturity of 20 years or more) are typically equal to or less risky than equities. The graphic shows the total return and standard deviation of returns (risk) over the past 2 years.
Long bonds are also the most negatively correlated with equities, meaning they are your best way to diversify your portfolio. The table shows the correlation between the four ETF asset classes over the past 2 years. A correlation of 1 means the assets offer zero diversification benefit and a correlation of -1 means they do the exact opposite. A correlation of zero means the returns of the assets have no correlation and that is optimal from a diversification standpoint. For longer-term investors, a low negative correlation is ideal to add a sleep-at-night benefit.
If we only looked at past returns, we would have an all-equity portfolio right now, and that may not be the best idea going forward.
From what I can tell from the weekly BNN viewer questions I've received over the years, most investors only consider returns when making investment decisions. Because unless you really do your homework, the risk numbers of assets are not well disclosed by the industry. People only tend to consider the risk side after it gets painful, and they have paper losses making them lose sleep.
I've been saying for years this is the biggest tragedy for do-it-yourself investors. Professionals have many ways of measuring how risky a position is, but individual investors do not.
The average investor really does not have a way to measure their portfolio risk. What does "medium risk" really mean anyway? In a passive ETF portfolio, it means that you better be okay with a 20-per-cent decline every 5 years or so. And with bond yields as low as they are, you do not get the same type of protection in a balanced portfolio that you once did.
I've been adding to my U.S. long bond position (TLT) in recent months as a way to "lower" my portfolio risk and increase my sleep-at-night factor, while not hurting my portfolio yield. Long bonds are far better at protecting your portfolio value than sitting in low-yielding cash. The important thing to remember is that being a tactical active investor is prudent if you know how to use all the tools that are available to you.
Do you want to learn more about how to navigate world markets better? I talk about how to build smarter ETF portfolios to deal with some of the uncertainties we may face in 2017 and beyond in my upcoming educational seminars across Canada. Registration is free at www.etfcm.com and you can follow me on my new blog www.bermanscall.com or watch me at Berman's Call Monday's at 11am ET. Follow me on Twitter: @LarryBermanETF on Facebook: ETF Capital Management.