Getting ahead by not falling behind

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By Max Osbon

Over time unforeseen risks can and will accumulate in a portfolio. Interest rate risks, market risks, inflation risks, default risks, and the risk of improper diversification are examples of potential pitfalls that must be persistently monitored.

Some of these risks are welcome – they bring the opportunity for greater returns. But others bring too much downside, with little or no opportunity for additional gain. Managing a well-diversified investment portfolio comes with the responsibility to identify and correct the accumulation of those unwanted risks (often called “uncompensated risks”).

Here’s a recent example of accumulated risk causing problems in “set it and forget it” portfolios:
Mid to long term duration bonds.

Remember that bond prices move in the opposite direction of interest rates. When interest rates were falling, as they have fairly consistently over the last generation, the market prices of existing bonds rose considerably. But now with interest rates at historic lows and very little room to fall any further, an allocation to mid-long term bonds simply has a very limited upside. However, with no limit on how high rates could go in the future, there’s boundless downside risk.

Holding these bonds means locking in to rates that can leave the investor losing ground if interest rates or inflation rise. It’s a danger affecting set it and forget investors who fail to monitor for unwanted risks.

Take risks that provide potential return

Isn’t a move out of mid-long bonds a speculative “active management” decision? No. We don’t recommend re-allocating assets to chase the best performing sectors, as active managers do. But we do recommend reducing or eliminating those risks that have become unnecessary. Again, this is not to be risk averse; we like risky assets because they provide the opportunity for returns. What we don’t want is to continue to hold assets that don’t balance risk and return.

As we mentioned in our recent article Why Do Allocations Change, the reason we make changes in asset allocations is to keep things unchanged. We rebalance to put portfolios back in line with client goals and to protect the relationship between risk and return. Modifications may be small, but attention to detail is important. Small repairs can make big impacts – especially when compounded over a generation.

Just as CEO’s constantly look for opportunities to increase their bottom line by cutting unnecessary costs, investors can boost potential performance by eliminating these unnecessary risks. That means monitoring for imbalances in all market conditions.

 

Max Osbon worked at Bloomberg for two and half years after graduating from Santa Clara University in 2010 with degrees in Mathematics and Finance. Max is currently traveling the world and submitted this article from Maputo, Mozambique. Follow his travels at www.neverinamerica.com.


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