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The Cost of Having a Taper Tantrum

Remember the Taper Tantrum in 2013?ย  That was when 10 year T-Bond yields rose about 1.3% off a floor of 1.7% and stocks also fell. Over a 6 month period the All World Stock Index fell about 9% and 30 year T-Bonds fell 15%. Even a 50/50 stock/bond portfolio of US stocks and Total Bonds fell 5%. It seemed like the perfect storm where stocks and bonds both fall making it impossible to hide. But getting scared into this event turned out to be a big mistake.

From the trough of the Taper Tantrum in June of 2013 a simple 50/50 All World Stock and 10 Year T-Bond portfolio generated 5 year average returns of 6.35% with an absurd standard deviation of 5.1. These were some of the best risk adjusted returns on record and they were even better if you were invested only in US stocks.

This result isn’t unique to 2013. And here’s the thing – stocks and bonds don’t really fall together at the same time over any extended period of time. Since 1928 stocks and bonds have had negative returns in the same year just three times.ยน There has never been a period in which stocks and bonds both had negative calendar year returns two years in a row. Heck, even from 1940 to 1980 when rates were rising persistently, stocks and bonds only had two calendar years in which returns were negative in the same year.

The reason for this is relatively straight forward – when rates are rising it tends to be because the economy is getting better. This means that stocks are becoming more attractive and long-term holders of bonds are getting a pay raise (ie, you’re going to be able to roll over your existing bonds into higher yielding bonds). These moments expose investors to a huge amount of short-termism behavioral risk because it can be frightening to think that diversification isn’t working or won’t work in the future. But these storms rarely persist for long periods of time.

So yes, 2018 has been a kind of crummy year for anyone who wasn’t fully invested in US stocks. But that’s the power of diversification at work – you just have to know that your whole portfolio won’t work all the time. And while we know that we’ll underperform specific stock markets at certain times we can sleep well knowing that, in the long-run, we’re unlikely to be exposed to specific market risk – the kind of risk that causes real long-term pain and exposes us to huge amounts of behavioral risk.

So hang tight while this storms rides out. History and common sense tells us that while stocks and bonds can fall at the same time in the short-term it’s highly unlikely that this will continue for a multi-year period.

ยน – Using US stocks and 10 year T-Bonds. Source: Aswath Damodaran.ย