If you’ve read my paper Understanding Modern Portfolio Construction you know that I like to think of all financial instruments as if they’re bonds. This is helpful for multiple reasons:
The thing about bonds is that they pay a specific coupon. So, a 10 year T-Bond paying 2.5% will pay you 2.5% for the next 10 years. If you have a 10 year time horizon then you can virtually guarantee that you’ll get 2.5% per year plus your principal upon maturity. That creates a really clean linear relationship between the time of issuance and maturity. In other words, if you buy the bond today and wake up in 10 years it will look like the bond exposed you to zero permanent loss risk over that time period. I apply the same sort of thinking to the stock market in my paper by calculating a 25 year duration. The stock market, is a lot like a super long maturity bond paying 8-10% per year.¹
Of course, that’s not how bonds (or most other financial instruments) work. They do expose you to the risk of permanent loss in the short-term. And the big problem with low yielding bonds is that they expose you to a lot of potential interest rate risk which creates a lot of short-term risk. If you’re uncertain about your time horizon or you’re worried about generating a positive real return then holding that 10 year bond for 10 years might feel really uncomfortable. This is why I say that the current low yield environment has turned every bond investor into a trader. You’d have to be nuts to buy a long maturity bond and actually hold it to maturity when the risk of a negative real return looks high.
What I most like about thinking of everything like a bond is applying the concept of price compression. You might remember a post I wrote back in 2014 describing the price compression in Biotech stocks. Biotech stocks are akin to a super high yielding bond. Let’s say it’s a 15% yielding bond just for fun. But what happens when that bond generates 25% compound growth as it did between 2010 and 2014? Well, that instrument is essentially pulling future returns into the present. Its future returns are compressing into the present. This price compression can create an environment where you’re likely to generate a very poor future risk adjusted return. And that’s exactly what’s happened to Biotech stocks since I posted that story over 2 years ago. They’ve generated about a 1% annualized return with a standard deviation of 25. You couldn’t have picked a worse risk adjusted return if you’d tried!
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