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Preparing for True Black Swans

Preparing for True Black Swans

September 18, 2017
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A Black Swan is an event that comes as a surprise and has a major impact.  Investors will often inappropriately refer to the bear markets of 2000-2002 and 2008 as Black Swan events.  However, bear markets do not come as a surprise, everyone knows they happen and they are built into every capital market assumption.  The Black Swan event in 2000 was the complete collapse of internet stocks and the NASDAQ with it.  Investors had come to believe that the old rules about corporate earnings didn’t apply and everyone was trading internet stocks.  The Black Swan event in 2008 was the collapse of home prices.  Nobody believed home prices could go down and everyone was a real estate investor.

As we approach the possibility of another bear market in stocks the true Black Swan event is what could happen with bonds.  Bonds have been in a bull market since the early 80’s when interest rates were in the 20’s.  Most investors have never seen a period when bonds declined in value and the underpinning of portfolio theory is that bonds will be a risk reducer to a portfolio and they will return 5-7%.  Conservative investors and those in or near retirement are told to have more bonds based on these assumptions.  Here is the problem, bond prices move inversely to interest rates.  The only reason bonds have done so well over the past 30 years is that interest rates have gone from 20% to zero.  Interest rates can’t have another run like that from here and we know the Fed wants to start raising rates.  In this environment, at best bonds will earn their coupon, which is much lower than the assumptions most people make about bond returns.  At worst bonds will lose money.  Either one of those outcomes destroys the underpinnings of portfolio theory.  If bonds earn 2-3% then retirees and near retirees won’t meet their retirement projections.  If bonds lose money then they will no longer be a risk reducer in a portfolio.

Will either of these events happen?  Who knows, my crystal ball is as cloudy as everyone else’s, but investors need to be prepared in case they do.

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