BERKSHIRE HATHAWAY Chairman Warren Buffett, in his most recent annual report, described an event that occurred at a Berkshire subsidiary last year. Late one night, a fire spilled over from a neighboring business, resulting in significant damage to the Berkshire facility, forcing it to shut down.
Fortunately, no one was injured and, as Buffett notes, the losses will be covered by insurance. Problem is, one of the company’s largest insurers was, as Buffett put it, “a company owned by . . . uh, Berkshire.” The lesson: Even the most well-managed enterprise—and a company in the insurance business itself—can find itself the victim of unintended consequences.
In recent weeks, I’ve been thinking a lot about this story. While we all understand the importance of diversification to manage risk, sometimes things go wrong in unexpected ways. Indeed, I’d argue the most unexpected aspect of this year’s turbulent financial markets is what’s happened to bonds. Traditionally, stocks and bonds have exhibited negative correlation, meaning that when one goes down, the other goes up. That’s what makes them such a powerful combination in a portfolio.
But this year, when stocks went down, most bonds went down with them. It was like finding a hole in a life raft. While this has since started to reverse, I think it’s worth pausing to understand what happened, why it happened and what lessons we can learn.
What happened? Let’s go back to Feb. 20, when stocks started to falter. At first, bonds were behaving in character, rising as stocks fell. In fact, for the first few weeks—between Feb. 20 and March 6—the bond market rose, just as expected. But then, over the following week, as the stock market’s losses deepened, the bond market started to decline, too. In all, the bond market lost nearly 9% in just that one week.
Certain areas of the bond market fared especially poorly. Between Feb. 19 and March 19, short-term corporate bonds lost 12% and high-yield “junk” bonds lost 19%. Even municipal bonds lost 16%. This was probably the biggest surprise. During this period, the only winners were U.S. Treasury bonds, with short-term Treasurys up around 2%.
Why did this happen? A number of factors came together at once. The first two are typical of any stock market downturn, while Nos. 3 and 4 are peculiar to this year’s situation:
While it’s difficult to quantify the relative contribution of each factor, it was the combination that caused the bond market to seize up in ways that, according to one analyst, hadn’t been seen in 40 years. Fortunately, the Federal Reserve, using its ability to effectively print money, has since stepped in. That has led to a significant, though not complete, recovery in most areas of the bond market.
What can we learn from this? I see three useful lessons. First, there’s nothing wrong with a belt and suspenders. I often talk about the danger of recency bias, which is our natural tendency to extrapolate from recent events. It’s dangerous because, until this year, the stock market had gone up nearly every year for 11 years.
The result was that many people got lulled into a false sense of security. This year’s market turmoil is a good reminder that it’s okay to build a little paranoia into your portfolio. That might take the form of a money market fund or short-term Treasury bills. There’s no science to this, except to be cognizant that risks exist in categories that we may not be aware of.
Second, remain diversified, even when it feels unprofitable. Another truism about investing is that every crisis teaches us something new—usually the hard way. In this case, it was that unique combination of four factors—two old and two new—that caused the bond market to come unglued. Next time, it will be something else.
All this is a reminder that our best and only protection is broad diversification. One investor asked last week whether he should move his entire portfolio into Treasurys, since those are what have held up best this year. It was a good instinct. After all, in finance textbooks they characterize government bonds as a “riskless” asset.
But my response was that nothing is guaranteed—not even Treasury bonds. In fact, you may recall the government shutdown in 2011 that caused U.S. government debt to be downgraded. Do I still feel very comfortable with Treasury bonds? Yes, absolutely. They’ve certainly been star performers this time around, but that may not always be the case.
The third and final lesson: Measure twice, cut once. If there’s one company that suddenly everyone knows, it’s Zoom, the videoconferencing company. It’s a great product and the stock (ticker symbol ZM) has enjoyed strong gains this year, up 123%.
But there’s another Zoom that has done even better. It’s an obscure Chinese company with no revenue that happens to be listed on the U.S. market and with a much better ticker symbol: ZOOM. As a result, this other Zoom’s stock, which in the past typically traded for about a penny a share, has shot up nearly 900% this year. The lesson: If you’re making changes to your portfolio in this environment, go slowly and be careful when making decisions under stress.
Adam M. Grossman’s previous articles include Keeping Busy, Harder Than It Looks and Manic Meets Math. Adam is the founder of Mayport Wealth Management, a fixed-fee financial planning firm in Boston. He’s an advocate of evidence-based investing and is on a mission to lower the cost of investment advice for consumers. Follow Adam on Twitter @AdamMGrossman.