The Importance of Portfolio Construction – On Building an Investment Program That Can Survive The Worst The World Can Throw At It
A few years ago, I wrote the following in a Coastwise Dividend newsletter (this is word for word):
When people think of bubbles these days, they invariably turn to Bitcoin which has indeed increased an astounding 1,600%+ in under 12 months. As this is a new currency with little to no basis to value it (as compared to a stock which can be valued based on various metrics including discounted cash flow), we will only know well after the fact if today’s prices represented a bubble or the buying opportunity of a lifetime (more likely the former than the latter, but stranger things have happened in the world of finance…..see below).
The real bubble may actually exist in something far more mundane than headline grabbing crypto currencies. I’m talking about a centuries old financial instrument called… drum roll please… a bond. That’s right, the time tested, ‘safe’ security entered unchartered territory recently when a staggering 5+ trillion (yes trillion with a “T”) dollars’ (or Euros or other currencies) worth of negative interest bonds were sold. Not low interest rate bonds (many of which also exist and which could get hit hard in a rising rate environment), but negative. All it would take is for interest rates to return to where they have resided for the other 99.99% of history – positive – for the losses to start rolling in. Investors buying negative interest rate bonds, which by definition lose money if held to maturity, may make Bitcoin speculators look conservative.
If the price of Bitcoin went to zero, a couple hundred billion dollars would disappear. Not a small number, but easily absorbable by our global financial system. Yet a small percentage increase in bond rates could wipe out many times this in wealth, not from gambling types speculating on the latest wild Bitcoin price swings, but on pensions, retirees, and other savers who can ill afford to take such a hit. A material increase in interest rates could make the internet dot com bubble burst seem small by comparison.
I’m not suggesting such an event is around the corner nor would it likely occur ‘overnight’ like the stock market crash of 1987. Interest rates tend to move more slowly than the price of stocks. But witness the relatively short period just a few years ago when the US 10-year treasury rate increased from around 2% to 3%, causing double digit losses in those widely held securities. Now imagine if trillions of dollars in negative interest rate bonds saw their yields turn positive and head north. While not as sexy as the latest internet stock crashing and burning, or the story of some taxi driver who made and then lost millions betting on Bitcoin futures, the impacts felt by a real bond bear market could cause material financial turmoil.
As the saying goes, be careful what you wish for.'”
Here is the lesson from this and other similar periods in history: spend less time trying to predict the unpredictable (short-term stock price swings, macro-economic events like unemployment figures and their short-term impact on stock prices, etc.). Instead, spend your time creating a financial plan that outlines what your near and long-term goals and needs are (Short term: pay for a monthly mortgage, take trips, fund retirement through monthly contributions, etc. Long term: have enough money once you stop working, buy a second home in 10 years, etc.). With a well thought out and executed plan, you will avoid being in a situation where you react to short-term events (even dramatic ones like we’ve experienced in the last 10 – 15 years), either because you didn’t plan well, or based on your emotions (usually fear). When investors buy negative interest rate bonds in a panic, when they sell otherwise great companies that are down 50% or more not because they need the money but because they ‘can’t stand it anymore,’ that tells me they did not do the work upfront to create a plan they can follow regardless of external conditions.
Bad things are going to happen in the world, economically and otherwise. It’s a fact of life. You won’t be able to predict what they are or when they will occur, but you can plan for their likely impacts on financial markets. If you construct a plan that can withstand anything the world throws at it (primarily through prudent asset allocation), then you will more likely avoid taking actions you will later regret – like buying negative interest rate bonds that get crushed in a few years, or selling a great company at a low – only to buy it back higher later on. These mistakes cost you hard-earned money you now won’t have for your future goals and needs.
At Coastwise, we emphasize the creation of a financial plan which has the effect of giving investors the confidence and peace of mind that they will be able to both survive and thrive in turbulent market environments that shall pass before long. Imagine the poor investors who bought negative interest rate bonds (and had the privilege of paying the borrower) thinking they were doing the safe thing to protect themselves from whatever they feared at that time – only to see the value of their holdings plummet as the inevitable normalization of interest rates occurred.