Pragmatic Capitalism

Capital for Living a More Practical Life

Bonds Valuations in Counter Cyclical “savings” portfolio

« Back to Previous Page

From what I understand, counter cyclical indicator seems to be focused on altering the equity allocation when the equity upside is diminished , however how does a saver know when or if bonds in the portfolio are “overvalued” or “overallocated”? (For bonds I assume we talking something like AGG or the international equivalent rather then IEF).

I think the underlying assumption here is that bonds are generally less volatile then stocks (particularly when the business cycle and thereby equity decline), though it seems we maybe “ignoring” if bonds themselves are expensive.

As Counter cyclical savers do we care about bond valuations in themselves?

Marked as spam
Posted on 06/19/2016 1:05 PM
Private answer

Hi DM,

We care about valuations in both asset classes, but we’re much more concerned with stock valuations because they’re so much more important to our portfolio’s exposure to permanent loss risk. Bonds, if held for the correct duration, shouldn’t expose you to an inappropriate amount of permanent loss risk. So, if you’re concerned about interest rate risk then your bond piece needs a lower duration. Let’s say it’s 5 years on average. Then you just have to get used to the fact that you can’t judge your portfolio’s performance on anything less than a rolling 3-5 year basis.

The stock market is so much trickier because it’s basically a multi-decade instrument with huge swings in prices. Telling someone to “just view it in the right duration” is stupid because most people don’t have rolling 25 year periods to judge their portfolios within. As a result of this, your stock piece and its duration expose you to much more permanent loss risk in the portfolio.

So, long story short is that we care about bond valuations, but they’re much easier to handle than stock valuations because you can fine tune the duration in the bond piece whereas the only fine tuning on the stock piece is its relative size to the bond piece….

Make sense?

Marked as spam
Cullen Roche Posted by Cullen Roche
Answered on 06/20/2016 4:14 PM
    Private answer

    Does any special magic happen when you match net stock duration with a net bond’s duration?

    Marked as spam
    Posted by MachineGhost
    Answered on 06/23/2016 1:38 AM
      Private answer

      They’re totally different vehicles. A stock’s duration is just a guess. A bond’s duration is measurable and can be calibrated within someone’s asset allocation. That is, the components can actually be dialed up and down. You can’t do that with stocks because stocks basically all have the same duration….I guess you could argue that low vol stocks, high dividend stocks or high quality stocks might have a lower duration, but I don’t know how reliable that is in practice….

      Marked as spam
      Cullen Roche Posted by Cullen Roche
      Answered on 06/30/2016 11:07 AM