Thinking well is a superpower. It’s not a character trait that receives much attention, but I’d argue, it’s what matters. All other qualities take a back seat to the ability to think well.
Thinking well is a consequence of deep understanding, and it’s that understanding which opens up the ability to problem solve and create in different angles. IQ matters, but not like an understanding of the subject at hand. If I have a boogered up bush hog, I don’t want the latest Ivy league grad’s help. I want the guy in overalls that’s farmed his whole life and does his own maintenance.
Investors’ ability to think well is being tested by this market. The SPDR S&P 500 ETF (“SPY”) closed April down -12.99% for the year. The iShares Core US Aggregate Bond ETF (“AGG”) closed down -9.43% over the same period. Longer term bonds, as measured by the iShares 20+ Year Treasury ETF (“TLT”), are down -19.05% on the year! There’s been next to no place to hide.
Think about those numbers. Investors who hold ‘balanced’ portfolios and have been trained that stocks are risky and bonds are conservative, have watched both sides of the coin take it on the chin year to date. TLT and exposures like it, have been a staple holding in many portfolios designed to protect against stock declines. I’m afraid the historical definition of what’s risky and what’s conservative may be a thing of the past.
No Risk, No Return
Generating a return requires assuming some risk. No risk = No return. If anybody tells you otherwise, run away.
Our job is to position for sufficient return while trying to understand the risk associated, as best we can.
We consider drawdown and longevity risk as enemies 1a and 1b. Drawdown risk exists, but positioning purely to avoid drawdown carries an even worse outcome as it exposes portfolios to holdings that will go broke safely. For example, holding a large near zero interest cash position while inflation is what it is, exposes portfolios to a level of negative real rates we haven’t seen in decades.
This is the issue all investors are dealing with, and the exact reason for our comments above about the historical definitions of what is risky and what is not.
To generate a return in today’s market, you’re almost forced to hold stocks, the historically defined ‘risk asset’. We are not in an environment where there’s sufficient compensation for the risk embedded in bonds, the historically defined ‘conservative asset’.
Consider this…as I type, the indicated yield on AGG (a measure of the overall bond market) is right at 2%. Holders of the AGG have lost nearly 5 years of annual income purely off price decline just through April. Again, what’s been defined as conservative in the past may not be so in the future.
Our entire thesis and portfolio process is designed to help solve the issues of today’s market. We aim to hold more stocks and less bonds while keeping risk in check through injecting the ownership of volatility (more to come on this front).
Windshield vs Rearview
What matters is what’s to come.
We believe stocks have greater potential for return and they can help defend against inflationary pressures. We believe bonds continue to have a) poor potential for returns, b) cannot help defend against inflationary pressure, and c) lack the ability to provide correlation benefits as they have in the past.
Therefore, we hold more exposure to stocks as return drivers of the portfolio. We understand that more stock exposure can lead to more potential for drawdown risk. To address, we blend in exposure to volatility in the form of market hedges – which have been effective so far and positioned for even more effectiveness if the current market drawdown gets worse.
Historically, bonds have been used as a risk mitigation tool. Portfolios have been able to dampen volatility by allocating to bonds as a way of driving slower. The need for great brakes was unwarranted. Bonds, even though they were a weaker engine, compensated you through yield, price appreciation, and correlation benefits to your stocks. Driving slower was ok. If you are looking through the windshield, allocation decisions of the past should not be as effective in the future.
Our approach is different in that we lack the dependence on bonds in favor of a blend of more stock and convexity through long volatility.
The market has been an incredible mechanism for compounding capital over longer periods of time. This simple fact gets lost in the headlines quickly…even quicker when those headlines are accompanied by negative price action.
There are going to be bad headlines, and potentially more negative price action. None of that changes our belief that the market is the most efficient vehicle for most investors to grow their wealth. It’s our job to help manage portfolios in a way that produces return streams that are digestible and sufficient. We aim to deliver returns streams that keeps behavioral issues at bay.
We’ve seen terrible decisions made during negative markets over the years. The current level of market and portfolio drawdown is close to the tipping point where worries become ‘ok, I’ve got to do something’. Zero, I repeat zero, of those decisions have improved an investors ability to compound capital. Emotional thinking is not our best thinking. We must continue to “think well”.
The Delta Team
Aptus Capital provided significant contribution to this content.
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The SPDR® S&P 500® ETF Trust seeks to provide investment results that, before expenses, correspond generally to the price and yield performance of the S&P 500® Index (the “Index”)
The iShares Core U.S. Aggregate Bond ETF seeks to track the investment results of an index composed of the total U.S. investment-grade bond market.
The iShares 20+ Year Treasury Bond ETF seeks to track the investment results of an index composed of U.S. Treasury bonds with remaining maturities greater than twenty years.
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