The idea of adding to or maintaining fixed-income exposure at a time of heightened market fear seems like a logical way to address risk. Lately, however, it hasn’t turned out the way financial planners and their clients had hoped.
Those who bolstered their bond exposure over the past two years wound up adding to fixed income just in time for one of the worst bond routs in recent history. The broad bond market, as measured by Bloomberg Aggregate Bond Index, is down nearly 13% this year through late September. This is after a negative return in 2021.
What went wrong? While the investment community might chalk up the problems to yet another black swan event, this miscalculation was actually rooted in the market’s fundamental misunderstanding of risk.
Traditional financial planning instructs investors to maintain a static allocation of fixed income—regardless of market conditions—in order to manage “risk.” The financial-services industry has spent much time, money, and energy in discussing how more fixed income lowers the risk in your portfolio. But what is risk?
Risk is one of the most widely discussed topics in the business. It is also one of the most misunderstood. The investment industry relies heavily on a statistical tool called standard deviation to gauge risk. In technical terms, standard deviation calculates the dispersion of a data set, relative to its mean. In other words, the more varied an investment strategy’s returns are, relative to its average return, the riskier that strategy is thought to be. Strategies with low standard deviation, where returns are tightly bunched up near their historic average, are considered more predictable and therefore less risky.
This view of risk emboldened investors to rebalance into bonds at a time of growing market turmoil, as the broad fixed-income market’s standard deviation, over the past three years, has been around a fifth that of stocks, implying that bonds are expected to lose less than stocks in a down year.
But relying on standard deviation to measure risk is flawed. It doesn’t gauge risk so much as it measures stability. The differences between the two are not usually noticed in a bull market, but they become evident in bear markets. Standard deviation only measures stability, relative to the recent past, not expected future performance.
To understand the shortcomings of this approach, look at the Bloomberg Aggregate Bond Index. At the start of this year, the three-year standard deviation for this broad bond benchmark stood at 3.4%, with an average annual return of 4.8%. This tells us that heading into this year, there was a 68% probability that bonds would return as much as 8.1% on the high end and 1.4% at the low end. There was a 99.7% probability that bonds would return as much as 14.8% or lose as much as 5.3%.
As it turns out, however, the broad bond market fell significantly more: The aggregate bond index was down 9.7% in mid-August, even though standard deviation said there was less than a 0.5% probability of such a magnitude of losses.
What was missing here was context. The market risks in 2022 were not about the variation of performance around their mean. They were about the specific economic and market factors that led to rising anxieties in the market in the first place. Specifically, they were about rising interest rates, which weigh on stocks, but threaten bond prices even more, and the return of inflation, which hurts bonds but benefits commodities tied to industrial production. Understanding the effect of economic factors on an asset class is just as important as the amount the returns have moved around their average in the past.
These considerations are particularly important for adjusting one’s strategy to reflect current circumstances. Some call this style of investing “tactical,” but we believe that tactical adjustments need to be taken a step further, going beyond broad allocation decisions and drilling down into individual holdings, based on the specific risks in the market.
Late last year wasn’t the time to double down on bonds. It was time to dial back on fixed income. It was also an opportunity to add exposure to commodities and to determine which types of commodities made the most sense in light of the economy and geopolitical concerns. For instance, when Russia’s invasion of Ukraine added to supply-chain issues, attention began to turn to natural gas.
The investing industry has long recommended a static approach to asset allocation or a tactical approach that relies on ETFs to make broad course corrections. This year has illustrated the insufficiency of those approaches.
Unfortunately, the stakes for misconstruing risk are higher now than in recent memory. While investors in the 1990s were able to generate a 6% return from U.S. Treasury bonds, today the return from “risk-free” Treasuries is closer to 3.5%, requiring investors to take on more risk for the same amount of returns they earned in the past. The challenge for investors now is to assume more risk—but in the right way.
Guest commentaries like this one are written by authors outside the Barron’s and MarketWatch newsroom. They reflect the perspective and opinions of the authors. Submit commentary proposals and other feedback to [email protected].
Why Standard Deviation Is the Wrong Way to Measure Risk in a Bear Market
Illustration by Alex Nabaum
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About the author: Rick Lear is the founder and chief investment officer at Lear Investment Management.
The idea of adding to or maintaining fixed-income exposure at a time of heightened market fear seems like a logical way to address risk. Lately, however, it hasn’t turned out the way financial planners and their clients had hoped.
Those who bolstered their bond exposure over the past two years wound up adding to fixed income just in time for one of the worst bond routs in recent history. The broad bond market, as measured by Bloomberg Aggregate Bond Index, is down nearly 13% this year through late September. This is after a negative return in 2021.
What went wrong? While the investment community might chalk up the problems to yet another black swan event, this miscalculation was actually rooted in the market’s fundamental misunderstanding of risk.
Traditional financial planning instructs investors to maintain a static allocation of fixed income—regardless of market conditions—in order to manage “risk.” The financial-services industry has spent much time, money, and energy in discussing how more fixed income lowers the risk in your portfolio. But what is risk?
Risk is one of the most widely discussed topics in the business. It is also one of the most misunderstood. The investment industry relies heavily on a statistical tool called standard deviation to gauge risk. In technical terms, standard deviation calculates the dispersion of a data set, relative to its mean. In other words, the more varied an investment strategy’s returns are, relative to its average return, the riskier that strategy is thought to be. Strategies with low standard deviation, where returns are tightly bunched up near their historic average, are considered more predictable and therefore less risky.
This view of risk emboldened investors to rebalance into bonds at a time of growing market turmoil, as the broad fixed-income market’s standard deviation, over the past three years, has been around a fifth that of stocks, implying that bonds are expected to lose less than stocks in a down year.
But relying on standard deviation to measure risk is flawed. It doesn’t gauge risk so much as it measures stability. The differences between the two are not usually noticed in a bull market, but they become evident in bear markets. Standard deviation only measures stability, relative to the recent past, not expected future performance.
To understand the shortcomings of this approach, look at the Bloomberg Aggregate Bond Index. At the start of this year, the three-year standard deviation for this broad bond benchmark stood at 3.4%, with an average annual return of 4.8%. This tells us that heading into this year, there was a 68% probability that bonds would return as much as 8.1% on the high end and 1.4% at the low end. There was a 99.7% probability that bonds would return as much as 14.8% or lose as much as 5.3%.
As it turns out, however, the broad bond market fell significantly more: The aggregate bond index was down 9.7% in mid-August, even though standard deviation said there was less than a 0.5% probability of such a magnitude of losses.
What was missing here was context. The market risks in 2022 were not about the variation of performance around their mean. They were about the specific economic and market factors that led to rising anxieties in the market in the first place. Specifically, they were about rising interest rates, which weigh on stocks, but threaten bond prices even more, and the return of inflation, which hurts bonds but benefits commodities tied to industrial production. Understanding the effect of economic factors on an asset class is just as important as the amount the returns have moved around their average in the past.
These considerations are particularly important for adjusting one’s strategy to reflect current circumstances. Some call this style of investing “tactical,” but we believe that tactical adjustments need to be taken a step further, going beyond broad allocation decisions and drilling down into individual holdings, based on the specific risks in the market.
Late last year wasn’t the time to double down on bonds. It was time to dial back on fixed income. It was also an opportunity to add exposure to commodities and to determine which types of commodities made the most sense in light of the economy and geopolitical concerns. For instance, when Russia’s invasion of Ukraine added to supply-chain issues, attention began to turn to natural gas.
The investing industry has long recommended a static approach to asset allocation or a tactical approach that relies on ETFs to make broad course corrections. This year has illustrated the insufficiency of those approaches.
Unfortunately, the stakes for misconstruing risk are higher now than in recent memory. While investors in the 1990s were able to generate a 6% return from U.S. Treasury bonds, today the return from “risk-free” Treasuries is closer to 3.5%, requiring investors to take on more risk for the same amount of returns they earned in the past. The challenge for investors now is to assume more risk—but in the right way.
Guest commentaries like this one are written by authors outside the Barron’s and MarketWatch newsroom. They reflect the perspective and opinions of the authors. Submit commentary proposals and other feedback to [email protected].
Source: https://www.barrons.com/articles/standard-deviation-risk-bond-market-51663857401?siteid=yhoof2&yptr=yahoo