In Berkshire Hathaway’s most recent annual shareholder letter, Warren Buffett shared his dire forecast for bond investors:
And bonds are not the place to be these days.Can you believe that the income recently available from a 10-year U.S. Treasury bond – the yield was 0.93% at yearend – had fallen 94% from the 15.8% yield available in September 1981? In certain large and important countries, such as Germany and Japan, investors earn a negative return on trillions of dollars of sovereign debt.Fixed-income investors worldwide – whether pension funds, insurance companies or retirees – face a bleak future.
Thus far, Warren’s negative outlook has proven correct with the yield on the 10-year U.S. Treasury bond rising to 1.74% through the first quarter, leaving bond investors with a negative (3.4%) return.* And with inflation expectations heating up, it is certainly difficult to build a bullish case for bonds. However, most individual investors do not have all their investable assets in bonds. Buffett only considers the investment merits as a standalone investment. Given that most of our clients own bonds within a diversified mix of equities, real estate, and other asset classes, we thought this would be an opportune time to revisit the role bonds play within the portfolio.
In its most basic form, a bond is a loan to a government entity, corporation, or individual consumer. The investor in a bond is the lender and expects to receive back the original principal along with interest over the life of the loan. Bonds have two main characteristics: quality and maturity.
Quality is a measure of credit risk or the likelihood that the entity will repay the loan. High-quality bonds carry lower interest rates to reflect the low risk of default. In Buffett’s example above, he discusses the U.S. Treasury bond, which has the highest quality and thus a lower interest rate. On the other end of the spectrum, a corporation with a “junk” credit rating will have a much higher interest rate to compensate investors for the additional risk of default.
Maturity is a measure of interest rate risk. Using bond terms, duration provides an estimate of how sensitive a portfolio of bonds is to changes in interest rates. As an example, if interest rates rise across all maturities by 1%, a bond portfolio with a duration of 10 years can expect to lose 10% in value without including interest payments. The interest rate risk increases with duration and vice versa.
Now that we have the basics in place, let’s discuss more specifically the role bonds play in a diversified portfolio. MarketWise is designed to produce the highest risk-adjusted returns, taking into consideration the long-term expected returns, volatility, and correlations produced by the different asset classes. Bonds play a critical role in that mix. We invest in high-quality U.S. government bonds with short to intermediate (two to five year) maturities with the sole purpose of mitigating risk and providing stability. For taxable accounts, we invest in municipal bonds, which play a similar role while producing tax-free interest. We also own Treasury Inflation Protected Securities (TIPS), which provide protection during inflationary environments.
The main function of bonds in a portfolio is downside protection. If stocks always went up, there would be little need for bonds or any other asset class. But as we were recently reminded last March, stocks do go down, and when they do, bonds provide that counterbalance, as they typically rise in value during equity bear markets or economic recessions. In fact, since 1976, there have been eight years in which stocks were lower. In each of those years, bonds finished higher to help cushion the blow. This allows us to rebalance during those periods and sell bonds when they are up and buy stocks when they are down in value.
Bonds also have very low overall correlation to stocks. During negative months for stocks, that correlation drops even further. But that also does not mean bonds always have negative returns when stocks are up. In fact, bonds are slightly positively correlated to stocks during up periods. We recently saw this in 2020 with both stocks and bonds finishing with positive total returns for the year.
So, despite the lower expected returns for bonds going forward, it is important to understand the characteristics of bonds and why we own them. That said, our team continues to research ways to improve the fixed income slice of the portfolio. Over the past several years, we added two specialized asset classes in Alternative Lending and Reinsurance to increase returns that are uncorrelated to both equities and bonds. Going forward, we will continue to investigate ways to enhance the role that bonds play within the portfolio.
Disclosure: The material is presented solely for information purposes and has been gathered from sources believed to be reliable, however Merriman cannot guarantee the accuracy or completeness of such information, and certain information presented here may have been condensed or summarized from its original source. Merriman does not provide tax, legal or accounting advice, and nothing contained in these materials should be relied upon as such. Any reference to an index is included for illustrative purposes only, as an index is not a security in which an investment can be made. Indices are unmanaged vehicles that serve as market indicators and do not account for the deduction of management fees and/or transaction costs generally associated with investable products. The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. All composite data and corresponding calculations are available upon request.
“The world makes much less sense than you think. The coherence comes mostly from the way your mind works.”
– Daniel Kahneman, Thinking, Fast and Slow
“It’s not supposed to be easy. Anyone who finds it easy is stupid.”
– Charlie Munger, Berkshire Hathaway
In its most basic form, investing involves allocating money with the expectation of some benefit, or return, in the future that compensates us for the risk taken by investing in the first place. Investing is a decision: buy or sell, stock A or stock B, equities or bonds, invest now or later. But as the great Charlie Munger reminds us above, investing is far from easy. Prior to making an investment decision, we create statistical models, build spreadsheets, use fundamental and technical analysis, gather economic data, and analyze company financial statements. We compile historical information to project future return and risk measures. But no matter how much information we gather or the complexity of our investment process, there isn’t one rule that works all the time. Investing involves so much more than models and spreadsheets. It is an art rather than a science that involves humans interacting with each other—for every buyer, there is a seller. At its core, investing is a study of how we behave.
Daniel Kahneman and Amos Tversky are famous for their work on human behavior, particularly around judgment and decision making. Judgment is about estimating and thinking in probabilities. Decision making is about how we make choices under uncertainty (which is most of the time). Kahneman won the Nobel Prize in Economics for their work in 2002, an honor that would have certainly been shared with Tversky had he not passed away in 1996. Their findings challenged the basic premise under modern economic theory that human beings are rational when making judgments and decisions. Instead, they established that human errors are common, predictable, and typically arise from cognitive and emotional biases based on how our brains are designed.
In his book, Thinking, Fast and Slow, Kahneman describes our brains as having two different, though interconnected, systems. System 1 is emotional and instinctive. It lies in the brain’s amygdala and uses heuristics or “rules of thumb” to simplify information and allow for quick gut decisions. In contrast, System 2 is associated with the brain’s prefrontal cortex. It is slow, deliberate, and calculating. As an example, if I write “2 + 2 =”, your mind without any effort will come up with the answer. That is System 1 at work. If I write “23 x 41=”, your mind most likely switches over to the slower moving System 2. While Systems 1 and 2 are essential to our survival as humans, Kahneman found that both systems, and how they interact with each other, can often lead to poor (and sometimes irrational) decisions. We can apply much of what Kahneman and Tversky discovered to investor behavior. Let’s focus on some of the most common biases and how they impact our decision making.
Kahneman and Tversky summarized loss aversion bias with the expression “losses loom larger than gains.” The key idea behind loss aversion is that humans react differently to gains and losses. Through various studies and experiments, Kahneman and Tversky concluded that the pain we experience from investing losses is twice as powerful as the pleasure we get from an equivalent gain. This can lead to several mistakes, such as selling winners too early for a small profit or selling during severe market downturns to avoid further losses. Loss aversion, if left unchecked, can lead to impulse decision making driven by the emotions of System 1.
Confirmation bias leads people to validate incoming information that supports their preexisting beliefs and reject or ignore any contradictory information. In other words, it is seeing what you want to see and hearing what you want to hear. As investors, we are prone to spending more time looking for information that confirms our investment idea or philosophy. This can lead to holding on to poor investments when there is clear contradictory information available.
Hindsight bias is very common with investor behavior. We convince ourselves that we made an accurate investment decision in the past which led to excellent future results. This can lead to overconfidence that our investment philosophy or process works all the time. On the flip side, hindsight can lead to regret if we missed an opportunity. Why didn’t I buy Amazon in 2001? Why didn’t I sell before this bear market? As I always say, I would put the results of my “Hindsight Portfolio” up against Warren Buffet’s any day!
As mentioned above, investors can become overconfident if they have some success. This can lead to ignoring data or models because we think we know better. As Mike Tyson said, “Everyone has a plan until they get punched in the mouth.” Overconfidence can lead to a knockout, and investors must be flexible and open with their process.
Recency bias is when investors emphasize or give too much weight to recent events when making decisions and give less weight to the past. This causes short-term thinking and allows us to lose focus on our long-term investment plan. It essentially explains why investors tend to be more confident during bull markets and fearful during bear markets.
I could write an entire book on investor psychology. The bottom line is that we cannot eliminate these biases. After all, we are all human. Even Kahneman, who made the study of human behavior his life work, admits he is constantly impacted by his own biases. However, there are certain actions or “nudges” that can help address such biases and avoid making costly mistakes. At Merriman, we have built the firm in such a way to use our knowledge about human behavior in the work we perform for our clients. Below are some of the main examples:
We build and design our investment strategies based on academic data going back hundreds of years. We are evidence-based rather than emotionally-driven investors. We think long term and do not let short term noise or recent events impact the process. We build globally diversified portfolios across different asset classes to produce the best risk-adjusted returns. That said, we are consistently researching and studying to find data that might contradict our investment philosophy and will make changes if the evidence supports it.
A well-built financial plan is at the core of our client’s long-term success. It is a living document that requires frequent updates based on changes in our lives—retirement, education funding, taxes, change in job, business sale, and estate planning. This forces us to make investment decisions based on the relevant factors of that plan and not on emotions—because at the end of the day, investing is meant to help reach our goals.
At Merriman, we do our best to help educate our clients on our investment philosophy. Blogs, quarterly letters, seminars, client events, and video content are all examples of tools we use to educate our firm and clients. Knowledge and awareness are powerful tools to help us make sound decisions.
We are all going through an extremely stressful situation right now—both personally and professionally. Now, more than ever, we need to lean on each other and show empathy and support through this unprecedented time. Remember, investing is a study of how humans behave. At Merriman, we want to be your resource to guide you through both calm and turbulent markets, helping you reach your financial goals. Please don’t hesitate to contact us if you’d like to discuss how we can help.
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