Detachment from market mood swings

After suffering one of the worst Decembers on record, these mood-swinging markets are back on a high. This might be a good time to check whether your portfolio is ready for the next bout of angst.

To reduce the effects of gyrating markets on our funds, we have to own defensive assets that should perform well when equities fall. Typically, that would mean having a solid block of government bonds – a safe asset that offers a small return and no currency risk. Today isn’t typical. The yield on 10-year UK government debt is nowhere near enough to offset inflation, so you’re losing about 1% of purchasing power each year you hold it. Because of this, we have a very small position in UK government bonds. In short, we think persistently low interest rates have made government bonds, which are known as “risk-free assets”, much less reliable as a defensive asset than in the past.

We’ve been purchasing more government bonds when yields rise to around 1.30% or higher (i.e. the price to buy them drops). But in the meantime, we have been using other assets to protect our portfolios from any sharp drops in stock markets (more on that later), and focusing our fixed income attention on foreign developed world government debt, including Australia, the US and Japan, as well as a very small amount of bonds issued by emerging market nations. Our substitutes for UK government bonds have been spread more widely, creating a “basket” of things that we think should bolster our funds when stock markets hit trouble.

This basket is an eclectic mix, but they all have one thing in common: they tend to go up and down at different times and to differing degrees than equity markets (low or negative correlations, in the parlance). By owning assets like this we reduce the amount our portfolio value changes from day to day and month to month. Essentially, it helps us reduce risk by ensuring we aren’t overly exposed to one thing or another, whether that’s the Chinese economy, US interest rates or the Australian property market.

Alternatives are a useful tool in this quest for low correlation. So, what kind of ‘alternative’ assets do we own? We buy foreign government bonds that have higher post-inflation yields than those offered in the UK. We have also stocked up on ‘safe haven’ currencies – those that tend to be bought up in times of economic or market peril. These include the Japanese yen and Swiss francs; we buy very safe bonds that are priced in these currencies and benefit when the exchange rate strengthens against the pound.

We also own gold. The yellow metal is erratic: no one can explain why its value bounces around day to day, and because it doesn’t pay any income it is both volatile and, counterintuitively, highly susceptible to inflation. The old investment adage of buying gold to protect your wealth from money-printing central banks inflating it away doesn’t quite sit well with us. Our research shows gold tends to be a poor way of protecting your wealth from inflation. However, gold has historically attracted many investors when things get rocky, pushing its price higher. So, holding a small amount can be a good way to reduce the volatility of your portfolio.

Many of our ‘alternative’ assets are quite volatile, which just means the price of them tends to jump around quite a bit. One of the traps you can fall into is investing in alternatives that are touted as lower risk because they have very low volatility. If there isn’t a ready market to sell something, it’s difficult to know exactly how much it’s worth. Instead you’ll take a guess that it hasn’t changed all that much and get on with other things. Some ‘alternative’ investments are similar to this. Because buyers aren’t readily available or because it’s too onerous to value assets very often, the investment’s value is assumed to be roughly stable. But when you come to sell, a lack of buyers and an opaquely priced market work against you. You may find out the assets aren’t worth as much as you thought …