Portfolio Insurance

Adam M. Grossman

A TEL AVIV WOMAN named Anat decided to surprise her elderly mother with a gift. Noticing that her mother had been sleeping on the same worn-out mattress for decades, Anat replaced it while her mother was away from the house. She then took the old mattress out to the curb.

It wasn’t until the next morning that her mother noticed the change and asked what had happened to the old mattress. Anat explained that she had put it out with the trash, which had since been picked up. This sent her mother into a panic. It turned out she had hidden her life’s savings in the old mattress—more than $1 million. According to news reports about the 2009 incident, they searched three different dumpsites across the city but never found it.

When I mentioned this story to a colleague, he described something similar. When his grandfather passed away, he helped clean out his house. In the freezer they found several packages labeled “fish.” These packages caught his eye because, he said, “there were a lot of them, and they didn’t look like fish.” As you can probably guess, when he opened them, he found piles of cash.

These stories are both funny and not funny at the same time. They’re also not unusual. According to a Marist College poll, people hide money in all kinds of places. More than 10% hide cash under the mattress. Even more hide money in the freezer. Other popular spots include the sock drawer and the cookie jar. There’s also the backyard.

I don’t recommend keeping cash in your home like this—unless it’s in a safe—but I understand the emotional appeal. A pile of cash is tangible in a way that a bank balance isn’t. Especially in a volatile world, it’s comforting to have a stable asset.

But amid today’s low interest rates, it seems many people are going to the other extreme—and shunning conservative investments. Prominent voices like hedge fund manager Ray Dalio are saying, “cash is and will continue to be trash” and bonds are “stupid.” Why is he so negative? Because today’s low interest rates mean that most bonds aren’t keeping up with inflation. Even Warren Buffett, who is far less of a gunslinger than Dalio, has said, “people who hold cash equivalents feel comfortable. They shouldn’t. They have opted for a terrible long-term asset, one that pays virtually nothing and is certain to depreciate in value.”

I understand this sentiment, but I don’t agree. I think it’s a matter of perspective. If you look at cash or bonds as a vehicle to make money, you’re almost guaranteed to be disappointed. In my opinion, however, that’s not why you want to own them. With cash and bonds, you aren’t trying to make money. Instead, they’re insurance—to help you avoid losing money.

In fact, I look at the bond side of a portfolio in the same way that I look at any insurance policy. Consider homeowner’s insurance. If, at the end of the year, your house is still standing and you haven’t made any claims, would you consider the premium you paid to have been a waste? Of course not. You’re glad nothing bad happened and likely don’t give a second thought to the small price you paid for insurance. This is even more true with health insurance and life insurance. We buy insurance to protect ourselves from all the things that could go wrong in life. In that way, dollars spent on insurance premiums aren’t wasted, but rather serve an important role.

Similarly, the role of bonds in a portfolio is to provide downside protection. In years when the stock market falls, that’s when bonds shine. When stocks were down more than 30% last year, retirees who needed cash to meet their living expenses hardly worried whether their bonds had lost a few percent to inflation.

In the finance literature, there is a framework called Roy’s Safety First Criterion. Published in 1952 by A.D. Roy, it provides a quantitative lens through which to see the value of bonds. Without getting into the math, the basic idea is that an investment should always be evaluated in relation to both its prospective return and its risk. Specifically, Roy’s formula uses the standard deviation of an investment—that is, the variability of its returns from year to year—to measure risk. It’s through this lens that I think bonds begin to make a lot more sense. Consider the following data from Morningstar:

  • Over the past 95 years, domestic stocks have returned an average 10.3% a year, with volatility of nearly 20%.
  • Over that same time period, short-term U.S. government bonds have returned 3.3%, barely ahead of inflation. But the volatility has been just 3.1%.

In other words, with bonds, you wouldn’t have gotten rich—but the losses, whenever they occurred, wouldn’t have caused you to lose much sleep. Here’s another way to look at the numbers. Over that same period, the worst year for an all-stock portfolio was a loss of about 43%. Meanwhile, the worst year for an all-bond portfolio was a loss of just 5.1%. That’s the value of bonds.

Won’t bonds lose value if interest rates rise? Yes, that’s a valid concern, and we’ve seen some of that this year. That’s why I’d stick with short- and intermediate-term bonds, which have the least sensitivity to interest rates. I would also invest only in government bonds. Of course, these bonds pay the least interest, but they also provide the greatest stability. The way I see it, if you’re going to buy insurance, you shouldn’t cut corners. Instead, you should secure the best coverage possible.

Are bonds the life of the party? Definitely not. But they still play a critical role: They’re like the designated driver who enables people to enjoy the party. And, in that way, they’re invaluable.

Adam M. Grossman is the founder of Mayport, a fixed-fee wealth management firm. In his series of free e-books, he advocates an evidence-based approach to personal finance. Follow Adam on Twitter @AdamMGrossman and check out his earlier articles.

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