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Preservation of capital
Deano
Posted: 22 May 2017 09:17:33(UTC)
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If equity markets continue to go up then they will most likely outperform most other asset classes. Hence the preservation piece is geared towards the times equity markets go down.

So the million dollar question is which asset classes will perform the best when equities go down. The answer is that it depends on the reasons for equities declining!

However, history shows that when investors sell equities they generally run to safe havens such as gold, government bonds and the US Dollar. So I would focus the non-equity part of a portfolio in these areas to protect against any equity market downturns.

Would I invest in bonds and gold in their own right? Probably not, but alongside equities as a hedge then I think it provides the downside protection that most investors should require.
4 users thanked Deano for this post.
Mickey on 22/05/2017(UTC), Ark Welder on 22/05/2017(UTC), Colin Deakins on 23/05/2017(UTC), c brown on 24/05/2017(UTC)
Law Man
Posted: 22 May 2017 16:49:50(UTC)
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Thank you everyone for the interesting posts.

I am in a similar position to the OP. While thoroughly unscientific, I know that emotionally I am influenced by having lived through periods when inflation was very high (which makes me wary of bonds, other than index linked) and aware that equities can collapse for long periods.

Conversely I am aware of age longevity which means I need my portfolio to keep pace with inflation for another 20 years plus. Age 65 does not mean you can be ultra cautious and forego further growth.

In case it helps, I found a very good book called Global Asset Allocation which costs only £1-99: see https://www.amazon.co.uk...d=1495471368&sr=1-1

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King Lodos on 22/05/2017(UTC), Colin Deakins on 22/05/2017(UTC), Money Spider on 22/05/2017(UTC), c brown on 24/05/2017(UTC)
King Lodos
Posted: 22 May 2017 17:15:36(UTC)
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There's the All Weather approach .. Troy Trojan and Ruffer could be considered tactical All Weather portfolios .. I'm surprised a company like Vanguard doesn't offer a low-fee equivalent – I think All Weather and Permanent portfolios would be right for 80-90% of investors.

Oh dear, attack of the giant images.

https://i1.wp.com/groww.in/wp-content/uploads/2016/12/Screen-Shot-2016-12-18-at-10.17.06-PM.png

https://i1.wp.com/groww.in/wp-content/uploads/2016/12/Screen-Shot-2016-12-18-at-10.18.54-PM.png

https://i2.wp.com/groww.in/wp-content/uploads/2016/12/Screen-Shot-2016-12-18-at-10.20.45-PM.png

https://groww.in/blog/all-weather-portfolio/
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jvl on 25/05/2017(UTC)
Alan Selwood
Posted: 22 May 2017 20:12:55(UTC)
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KL:

I don't follow all of your Jolly Green Giant images panel:

Surely if inflation is high and you expect markets to fall, you would not want to be in long term bonds. (Bottom right-hand corner)

Especially if we had a rerun of the early/mid-1970s, when both equities and bonds fell heavily.
Money Spider
Posted: 22 May 2017 20:29:15(UTC)
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Great thread and I'm comfortable with the concepts of 'The Permanent Portfolio', 'All-Weather Approach' and Mickey's variation on The Permanent Portfolio.
BTW, I took a look on Amazon to maybe read more background on The Permanent Portfolio. The reviews included a posting by a Brit (P A Glover) who is using it to manage his SIPP. I think he's made some mistakes in the (UK)ETFs he's chosen, but he posts his returns whilst using the approach for 3 years (2014-2016).
https://www.amazon.co.uk...-Strategy/dp/1118288254

My concerns relate to the current environment: QE, ultra-low cash returns and low/negative returns on gilts. The system is out of equilibrium. I'm comfortable with the Equity and Gold components, it's the unattractiveness of gilts and holding large amounts of cash that trouble me. Am I missing something?
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Mickey on 23/05/2017(UTC)
Alan Selwood
Posted: 22 May 2017 20:49:49(UTC)
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I don't think you are missing anything, money spider.

QE has lots of inbuilt sins - it has distorted supply and demand, forced interest rates to be lower than they would no doubt have been in a QE-free environment, so they have forced gilts higher than they have any justification to be.

Equities have done well, mainly, I suspect, because the lack of income from cash and gilts has forced people to overweight equities, so their longer-term performance could be at risk, just as future capital values of gilts look to be at high risk, IMHO.

I reckon also that gold would have got to a higher price against the various fiat currencies (since it normally thrives on negative real interest rates), if it was not for dodgy behaviour by central banks and synthetic ETF fund suppliers.
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Mr Helpful on 23/05/2017(UTC), c brown on 24/05/2017(UTC)
Stephen B.
Posted: 22 May 2017 20:58:19(UTC)
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Cash doesn't have the capital risk of bonds, so if you really want to preserve capital it does that, but with essentially zero interest it's a deadweight in a portfolio - 50% in cash basically halves your returns.
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Mickey on 23/05/2017(UTC)
Stephen B.
Posted: 22 May 2017 21:02:47(UTC)
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BTW, I think it's worth pointing out that low bond yields are a benefit to many companies that issue bonds, they are often borrowing at much lower rates than they would have in the past and hence their return on equity is higher.
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Alan Selwood on 22/05/2017(UTC), Mickey on 23/05/2017(UTC)
Ark Welder
Posted: 22 May 2017 22:27:23(UTC)
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The 30-year bull market in bonds has been good for equities too, so why assume that a bear market in bonds won't have a detrimental effect on equities?

The progressively lower cost of borrowing is fine for those companies that have used the proceeds to invest in growing the business because the company should be in a better position to service an increase in the cost of debt from the resulting growth in revenues once the coupons on new debt start to rise. But what of those companies that have basically squandered the cash raised by buying back shares or supporting dividends? For these companies, a future increase in the cost of servicing the debt is more likely to leave less for shareholders: less revenue available for dividends and certainly less for share buybacks.


Stephen B.;47060 wrote:
...but with essentially zero interest it's a deadweight in a portfolio - 50% in cash basically halves your returns.

Not in a deflationary environment it won't, which is also a scenario where long-dated bonds should continue to prosper.


Alan Selwood;47055 wrote:
KL: I don't follow all of your Jolly Green Giant images panel:

Surely if inflation is high and you expect markets to fall, you would not want to be in long term bonds. (Bottom right-hand corner)

Not high inflation and falling markets, but high inflation and market expectations that inflation will fall. In which case, long-dated bonds ought to prosper because falling inflation will likely lead to falling interest rates. Basically, the situation back in the early 1980s at the start of the bond market run.

What I would question in that table is the Floating Rate bonds in the bottom-left corner. Falling growth ought to result in lower inflation, therefore lower interest rates. So whether the floaters are interest or inflation linked, the distributions from them ought to be reducing too.

Also, equities in the bottom-right corner: if expectations are that inflation will fall due to technological advancement, then fair enough; but if it is due to lack of demand then equities are debatable - especially if expectations are for deflation.
Alan Selwood
Posted: 22 May 2017 22:29:01(UTC)
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Yes, I noticed the other day that one new borrowing was taking advantage of current low rates while waiting for an earlier long-dated borrowing at relatively extortionate rates to mature very soon.
Alan Selwood
Posted: 22 May 2017 23:02:30(UTC)
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Ark Welder:
Thanks for the clarification. I agree entirely that if inflation falls gilts should do well, as per the situation in 1980+ (Boy, was that a good time to buy gilts!!)
King Lodos
Posted: 23 May 2017 00:07:49(UTC)
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Alan Selwood;47055 wrote:
KL:

I don't follow all of your Jolly Green Giant images panel:

Surely if inflation is high and you expect markets to fall, you would not want to be in long term bonds. (Bottom right-hand corner)

Especially if we had a rerun of the early/mid-1970s, when both equities and bonds fell heavily.


It is actually a really confusing style of chart for me .. I don't know quite how they manage to make it so awkward.

But as mentioned, Long-term Bonds are basically in the Deflation and Recession squares (falling expectations for both).


Micawber
Posted: 23 May 2017 07:42:03(UTC)
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Ark Welder;47062 wrote:
...why assume that a bear market in bonds won't have a detrimental effect on equities?

Indeed. Rising interest rates and rising bond yields will have a negative effect especially on income producing equities as well as highly indebted ones.

But capital flowing out of bonds in a bond bear market will be looking for homes other than cash, too.

Then there's the usual consideration of risk...

All told, there's no sweeping statement that can confidently be made. You have to look at individual sectors and stocks within them.

Quote:



Stephen B.;47060 wrote:
...but with essentially zero interest it's a deadweight in a portfolio - 50% in cash basically halves your returns.

Not in a deflationary environment it won't, which is also a scenario where long-dated bonds should continue to prosper.

The key underlying question. Is the weight of vast debt, and the wish of governments to reduce it together with its servicing costs, sufficiently deflationary to continue to suppress inflation, or can sufficient inflation be generated (by further vast borrowing....) to reduce its real value? The QEs and continued increase in debt over the past few years suggest that the former is more likely, to me (only the weakest inflation has resulted from it). The latter risks eventual collapse.



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Ark Welder on 23/05/2017(UTC)
Mickey
Posted: 23 May 2017 07:47:00(UTC)
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Stephen B.;47060 wrote:
...- 50% in cash basically halves your returns.

Not necessarily, with 50% in cash you could decide to take on higher risk equities, I think KL or someone mentioned they tend to have an approach similar to that. But yes, holding cash reduces return as does holding something such as Personal Assets.
Stephen B.
Posted: 23 May 2017 08:56:54(UTC)
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Ark Welder;47062 wrote:
The 30-year bull market in bonds has been good for equities too, so why assume that a bear market in bonds won't have a detrimental effect on equities?


The reason for rising interest rates is likely to be that economic conditions are normalising, so in general I'd see that as good for equities. To be clear, I'm not suggesting that I expect 30-year gilts to go back to yielding 12%, just to their traditional 4-5%. In fact when I was looking at the history I was surprised at how stable it was - basically in a couple of years after the BoE became independent the yield dropped from about 8% to 4.5% and then stayed there for many years - even in 2014 it was about 3.7%, so the big squeeze is really just the last couple of years.

Ark Welder;47062 wrote:
Not in a deflationary environment it won't, which is also a scenario where long-dated bonds should continue to prosper.


I don't see any likelihood of sustained deflation. The BoE can print unlimited amounts of money and if it does that enough it will definitely generate inflation. For example, it could directly allow the government to increase spending using newly-printed money without increasing taxes or debt (at the moment the gilts the BoE has bought still sit on the government's books and have to be serviced).
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Mr Helpful on 23/05/2017(UTC)
Mr Helpful
Posted: 23 May 2017 09:34:20(UTC)
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This link gives some further perspective re Gov't Bond (albeit US) history.

http://www.multpl.com/10-year-treasury-rate
Ark Welder
Posted: 23 May 2017 11:07:18(UTC)
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Micawber;47076 wrote:
But capital flowing out of bonds in a bond bear market will be looking for homes other than cash, too.

Somewhat peversely, rising bond yields will make new bond issues more attractive. The distributions from those higher coupons will benefit the cashflow situation of the holder.

Other points to consider is that not all investors will necessarily need to sell. Pension funds look to match long-term liabilities with long-term assets, and insurers need to cover potential liabilities for which the volatility and drawdown potential of equities might be inappropriate, least to some degree. Somewhat captive holders, and likely to be holders until redemption which should mitigate price movements until then.

The other apparently peverse situation is where some equitites will benefit from a rise in bond yields are those with large pension liabilities and/or deficits: actuarial alchemy should mean that these schemes will require reduced funding from the relevant companies, meaning that there more of the revenue can be put to other purposes, e.g. reducing the amount of other debt or paying dividends.
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dyfed on 24/05/2017(UTC)
Stephen B.
Posted: 24 May 2017 11:35:11(UTC)
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In terms of inflation vs deflation I just had a look at the ten-year history, so starting just before the financial crisis. Despite all the gyrations over that period the average CPI inflation is 2.3%, so well within the target range and if anything slightly on the high side. (The 20-year performance, so basically since the MPC was created, is almost exactly 2%.) People tend to just focus on one-year figures, but in recent years most of the excursions in inflation have been down to swings in commodity prices which have cancelled out over longer periods.
King Lodos
Posted: 24 May 2017 17:55:49(UTC)
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Stephen B.;47060 wrote:
Cash doesn't have the capital risk of bonds, so if you really want to preserve capital it does that, but with essentially zero interest it's a deadweight in a portfolio - 50% in cash basically halves your returns.


Only if you don't rebalance.

Rebalancing is basically what makes asset allocation work, and how you make a portfolio efficient. (whether you're rebalancing to fixed or tactical allocations)

Having cash gives you the ability to buy when markets fall, and limits absolute losses .. So as you add cash or bonds to a portfolio, the probability of a really bad outcome (like an 80% drop in stocks) across a portfolio rapidly diminishes, while the probability of matching 100% stocks only declines gradually.

Of course it depends what markets do, but the fact they can do anything is why there's a risk premium.

Here's 100% Developed World ex-US stocks (Total Return) vs 50:50 Dev-world stocks and Cash. From 2000 onwards, rebalanced annually. Of course 2000 was an expensive time for stocks (as it might be now), but while the results have been about the same, you've done it with much less risk in the 50:50 portfolio, and much more chance of a satisfactory outcome – even though you would normally expect it to trail 100% stocks .. And another drop in stocks, and 50% cash may be ahead over 20 years straight.

http://i.imgur.com/5HIMipf.jpg
Stephen B.
Posted: 24 May 2017 18:53:16(UTC)
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You still aren't addressing the fact that your historical comparisons had much higher interest rates. Looking at your figures, you have a CAGR of 3% for the equities which is obviously rather poor as it includes two very bad periods - but still it could be that equities will do badly again. However, with interest rates at close to zero I find it very hard to believe that your 50% cash portfolio would only reduce the overall return by such a tiny amount - cash was yielding more than 3% for quite a lot of that period, so it's hardly surprising that it wasn't a drag. Looking by eye, if you reset the graph at the market peak in 2011 (where rates were much lower) portfolio 2 would still be significantly worse overall even given the impending market crash.
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