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Correction of my Portfolio – Ditching Intermediate-Term Bonds

This post was first posted on my Patreon blog on 20 July 2020, where I make certain post (besides monthly updates) available in advance. Read more here about why I am on Patreon.

Hello fellow risk parity investor,

It is time for a kind of blog post that I hope will be as few in number as possible, but which I fear are inevitable from time to time. I have corrected a mistake, and want to tell you about it.

In my All Seasons Portfolio, I have until 20 July 2020 (the time of writing this post) held a certain amount if intermediate-term treasury bonds, i.e. bond with a duration of less than 10 years. I have held this in addition to my long-term bonds (20+ years) as part of the bonds portion of the portfolio. The splits have been 10% intermediate-term bonds and 30% long-term bonds, out of the whole portfolio.

As I have come across new and better information, I have chosen to reconsider the decision to hold intermediate-term bonds. They are not a bad investment as such – on the contrary, they are good when considering the risk-adjusted return – but they do not suit the All Seasons Portfolio Strategy. 

Why buy intermediate-term bonds?

Treasury bonds, and government bonds issued by other countries of high credit worthiness (credit rating of AAA-AA), are considered a more or less risk free investment which is equal to holding cash. 

By holding short-term treasury notes, such as 1-month treasury notes, this is the equivalent of holding cash, and, consequently, the yield on those notes, is the equivalent of the return of cash. 

All other investments should yield above that cash rate. This is because when you trade your cash for an asset, you should be rewarded for the risk you are taking by holding that asset instead of cash. Such excess return constitutes the risk premium. This means that if your stocks yields equal to or less than the cash rate, you have received no compensation for the risk you have taken, as you could have only held short term treasury bonds – a virtually risk free asset – and been compensated similarly.

All bonds issued by a state with high credit worthiness are considered risk free. This is regardless the term of such bonds, whether 1 month or 30 years. This is because regardless what happens, the bonds will be redeemed with interest, because all the state has to do is to print enough money to be able to cover the principal and interest as they fall due, be it in 1 month or 30 years. Even if the yield is different between bonds with different maturities, this only reflects the market assumption of what interest rates will be in the future (the yield curve), but the return in excess of the cash rate will remain mostly constant for all bonds.

In general, when deciding between whether you should buy long-term or intermediate-term treasury bonds, you are wise to look at the risk-adjusted return for each of these two types of bonds. Both have the same excess return above the cash rate of about 1.4%, but long-term bonds are more volatile, as changes in interest rates have greater impact at the far end of the yield curve. Therefore, when only choosing between these two bonds, the intermediate-term bonds have much better risk-adjusted return (because risk = volatility).

Why better risk-adjusted return is not better in an All Seasons Portfolio

While better risk-adjusted return usually is better when choosing between two assets, this is not the case when you are using a balanced portfolio strategy such as the All Seasons Portfolio.

This is because in this case, you want the volatility. When the financial markets would enter an environment that benefits bonds, you want that increased volatility to help you offset the loss in other assets you may hold. For example, if financial growth comes in lower than expected, stocks will decrease in value and bonds will increase. In such situation, you want your increase in bonds to offset the loss in stocks. If you would hold bonds with low volatility, you would not achieve this, and you portfolio would make a loss due to it being imbalanced from a risk parity perspective.

So, while intermediate-term bonds are better than long-term bonds when it comes to risk-adjusted return, they are inferior as a component in an All Seasons Portfolio.

Change to my All Seasons Portfolio

In my All Seasons Portfolio, I have until July 2020 held a certain amount of intermediate-term bonds. The reasons behind this has been twofold: 1) that intermediate-term bonds have better risk-adjusted return and should be superior, and 2) that intermediate-term bonds offer better protection against sudden central bank’s steering rate increases.

These are two fallacies that I have mistakenly fallen for, and I must therefore change my portfolio accordingly. I have explained already why fallacy no. 1 was erroneous in this particular situation, but as for fallacy no.2, I was wrong. I have since learned that sudden movements of steering rates by central banks is a risk that you cannot diversify. All assets (not only bonds), regardless of their duration, will be negatively affected by sudden increases in market interest rates. Therefore, I have realized that intermediate-term bonds have not offered me any more protection against this than long-term bonds, why there is no reason whatsoever why I should include intermediate-term bonds in my portfolio. 

In my opinion, it is important to stay humble when investing and be careful with confirmation biases. One must be willing and open to changing one’s opinion if new or better information becomes available.

I have lately gotten reasons to question my choice in including intermediate-term bonds in my portfolio, after that I had believe that they added value to my portfolio. But, following comments received on the blog (thank you!) and having read the book Balanced Asset Allocation by Alex Shahidi, I no longer had a good reason to remain convinced that intermediate-term bonds was a good choice.

If it does not work – make a change

In fact, I believe, that they are one of the causes for why my portfolio has lagged during the first half of 2020, as I did not get the bump upwards in my bonds portion of the portfolio to offset the fall in stocks and commodities. This is of course unfortunate. 

However, I feel it is better that I have realized my mistake now and made a correction, rather than sticking to my previous decision and kept going. 

Therefore, I have sold all my intermediate-term bonds, and allocated that capital to inflation-linked bonds and long-term bonds, so that I now will have an aimed allocation of 15% TIPS and 40% long-term treasury bonds (and thus getting rid of 10% intermediate-term bonds that I had in my portfolio). I feel confident with this new allocation and believe it will be best going forward.

I hope that this short text on my mistake can be at all helpful for you. It has at least helped me to sort my thoughts, but mainly, I share this kind of content so that you do not make similar mistakes as I do, or fall in the trap of confirmation bias. 

I realize this is not the first mistake I have made that I have shared about on the blog, and I do not think it is the last one. I see investing as a constant learning process, especially when it comes to such a specific investment strategy as the All Seasons Portfolio Strategy. And by being open about what I do, I feel it is important to share also when I do something wrong. I actually look forward to all future comments about how I mess up, as I hope we can both learn from thinking critically. 

Now that I have ditched my intermediate-term bonds today, I feel more harmonic, and confident that my portfolio is getting closer to its ideal shape. I am still wrestling with other questions, such as whether my stocks should be exposed to S&P 500 or FTSE All-World indexes, and whether my Commodities ETF is the best pick when considering the rolling of the futures and whether I should only include soft commodities. However, I hope to find some answers to these questions in the future. Any input here is highly appreciated.

What wrong decisions have you made that you wished you had discovered sooner (not counting back-trading such as “buying Tesla 5 years ago”)?

Thanks for taking the time to read, and look forward to our next encounter,

This Post Has 3 Comments

  1. Carlo

    Hallo Nicholas. Agree 100% with removing of intermediate bonds. Anyway I think 40% of long term bonds is really too much. I would increase tips (some risk parity allocations have 30% tips) or adding emerging market bonds. Also think a small portion of btc is mandatory as an insurance again the crush of the dollar as a currency. See you next month. Bue

    1. Nicholas

      Ciao Carlo,
      Yes, I think you are one of them who have been saying this in the comment section for quite some time, so finally I listened? ?
      Perhaps I have too little TIPS. I have been thinking what would be a better allocation, but at least bumping it up 20%, maybe 25%. I have not decided on that yet though.
      BTC can be a good asset as well, but I am not sure if the main reason for its inclusion is that the dollar will lose its title as the global reserve currency. I work in banking with loans to corporates, and there is no way that BTC will be the currency in which a loan is made any time soon. Rather, if the USD would go bust, the financial world would primarily turn to other fiat currencies and designate them as the reserve currency, for example the sterling, euro or yuan. However, as the dollar is so widespread globally, it will not be so that another currency simply replaces it, but rather you would for a longer time have several currencies competing for the reserve currency status, and I believe they will only be victorious in certain parts of the world (euros in Europe, yuan in Asia and Africa, etc.)
      However, BTC, or a basket of the greatest cryptocurrencies, will do well in a time when trust in central banks (not only the Fed) will have fallen rapidly. At one time, I believe we must turn to a stablecoin, and I am not sure if it is BTC, but as it will take long time before we reach that stage, BTC will be a great option and a good hedge.
      I think I may have swerved away a bit from the topic, but hope you don’t mind. How much TIPS do you think is a good option? Did you follow Alex Shahidi’s recipe of 30% long-term bonds and 30% inflation-linked bonds?
      I’ll serve you with the July monthly update later this week ?

  2. Carlo

    Thanks for the great analysis on the fiat currencies
    and on btc. It was very informative for me. My tips allocations fluctuate from 20% to 25% and so my long term bond. I have little more equity and gold than the standard all weather portfolio. Also I take 10% of the portfolio in cash to add it “tactically” to some the assets

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