Not going to sugarcoat it — this morning’s coffee is a bit stronger than last week’s brew and a little more Irish in nature if you catch what I am saying. It has been another long, turbulent week in the financial markets which has led to another record-breaking development. If you recall, last week’s market price action led to the fastest market correction in history and now this week investors had to contend, and be spooked, with record lows in U.S. interest rates. But, to be honest, our Investment Committee did not find these events surprising as we’ve been highly vocal of the economic slowdown that began in Q1 of 2018; the euphoric sentiment across market participants; and the volatility that ensues during growth rate inflections. In historical context, the market price action, while more sizable in magnitude this time around, is quite common during these periods of changes in economic growth rates. Nonetheless, periods of outsized volatility, especially during unforecastable events such as Coronavirus, leave investors anxious and uncomfortable as the majority of investments are sold in preference for risk stability assets.
Over coffee today, I am going to highlight the importance of why having an allocation to risk stability securities is paramount during times of economic uncertainty, event-driven shocks, and market drawdowns. So grab your cup of coffee as we dive through the importance of why risk stability securities play an integral role, not only in your financial plan, but your portfolio construction process.
For the high-speed espresso drinkers, here is a quick bullet point synopsis:
- US Treasury yields and mortgage yields hit record lows
- Risk Stability Assets are the only securities that buffered your portfolio
- Spikes in risks lead to spikes in correlation
- Maintain faith in your financial plan
Before we dive into the meaning of risk stability investments, it is important to take a step back and recognize the beginning foundation of investment portfolio construction. In the 1950’s a brilliant man, and Noble Prize-winning economist, Harry Markowitz, introduced a new concept on how to design investment portfolios known as Modern Portfolio Theory (MPT). His concept not only revolutionized our industry, but gave us the tools to mathematically model an investor’s risk tolerance and reward expectations. While the scope of our conversation is more focused on the concept rather than the mechanics, it is important to understand the two main principal components that MPT relies on for portfolio construction: return expectations and the risk expected per investment. The goal is to design an investment program by combining a multitude of investments in the aim to maximize the amount of return one can achieve while minimizing the level of risk associated. In sum, it allowed us to assess how much risk an investor is willing to take at the desired level of return they are wanting to achieve. As you will see in the chart below, there has been an indisputable relationship between the return achieved relative to the risk taken. This method of investment portfolio construction has been the bedrock for investment practitioners alike in the latter part of the 20th century and is still widely used today.