December 14, 2018
When you work with a guy who can fly an airplane 600 miles an hour without looking out the front windshield, it keeps your ego in check. So when Hans Smith here at One Day In July told me I needed to write about risk in the markets, I listened.
Over the fall and winter investors got re-introduced to risk. At least in the news media, many people had forgotten our old friend, the other side of the coin from "return." In middle school, risk would be described, in today's lingo, as a "frenemy." Part friend, part enemy. (Hey, it's middle school, these things change over the course of a day.)
Why is risk possibly a friend? If you are an asset buyer, other people changing their behavior, or having their hand forced, due to too much risk can be beneficial to you. But for this situation to develop, as an investor you must have your own risk controls established.
An endemic problem in portfolios is that risk is hiding in places people, even professional investors, do not understand. Nobel Laureates blew up Long Term Capital management and almost the U.S. financial system in 1998 due to their miscalculations on risk. They were not available for an interview, so I'll stick with some charts.
The blue line below is the iShares Long-Term Treasury index, composed of long-term, direct obligations of the U.S. Treasury. It has elements of risk in it, like interest rate risk, or risk from inflation. But unless the U.S. Constitution is violated, it has no default risk. The red line below is an iShares index of "high-yield" bonds. Another name for high-yield bonds, which you may remember from the Michael Milken days, is "junk bonds." They generally pay higher interest rates than Treasuries.
The two graphs below are total return graphs, in that they include both interest and capital return of the bonds.
What happened when some fear crept into the markets in November? Immediately the high-yield index dropped, and the long-term Treasury index soared. In just over a month it opened a 6% spread. Right when you wanted protection from the high-yield bonds, they failed to deliver.
But the graph above is very short term, and is meant to demonstrate reactions based on emotion. Let's increase the timeline and look at what is going on. Below is the Treasury index, in blue, from the spring of 2007 to the present. The high-yield index is in red. Notice that the ups and downs of the high-yield index are similar to a stock index. The needed diversification, and risk reduction, is occurring in the Treasury market. Ironically, the Treasuries also outperformed over this time period.
Oh, and even index fund to index fund, the Treasury index was less than a third the price of the high-yield index. Better protection from risk, better performance, and lower price.
Sources for graphs: stockcharts.com TLT vs HYG 11/5/18-12/13/18 and 4/11/07 - 12/13/18. Sources for index pricing: ishares.com 12/14/18: 0.49% HYG vs 0.15% TLT. / Philippe Jorion, University of California Irvine: Risk Management Lessons from Long-Term Capital Management