From Our Briefings Newsletter

Published on22 OCT 2018

The article below is from our BRIEFINGS newsletter of 22 October 2018:

Briefly . . . Managing Bear Market Risk 

The recent pick-up in market volatility has rattled investors enjoying the longest bull market on record for balanced portfolios consisting of 60 percent equities and 40 percent bonds. How can investors guard against the risk of a `Balanced Bear’ – a drawdown where both asset classes might experience meaningful declines at the same time? We caught up with Goldman Sachs Research’s Christian Mueller-Glissmann on lessons that can be drawn from previous market declines.

In a research note you published last year, The Balanced Bear, you argued that while equities and bonds appeared expensive relative to history, a full-fledged bear market was unlikely in the near term. Where do we stand today?

Christian Mueller-Glissmann: We still think lower risk-adjusted returns for balanced portfolios made up of 60% stocks and 40% bonds are more likely than a large sell-off in both asset classes. High valuations alone are not sufficient for a drawdown – and valuations across assets have in fact started to de-rate this year. An increase in bear market risk in equities, bonds or both requires a material growth or inflation shock, but typical drivers remain absent despite the long cycle. Still, we have seen a pickup in drawdowns this year, both in February and just recently, with both bonds and equities falling together. With a worsening growth and inflation mix in most markets, we think there is potential for more volatility.

What does history tell us about the risks of trying to time the market?

CMG: Being underinvested, particularly late in the economic cycle, can be costly since both equities and bonds tend to perform well up until the start of a bear market. Since 1990, the S&P 500 has delivered an annual return of about 10%. While investors would have reaped returns of close to 18% if they had avoided the month with worst returns each year, missing out on the month with the highest returns would have proved costly as well. In the latter scenario, returns would have dropped to 1.5% per year – lower than those for 10-year U.S. bonds. While the reward for perfect market timing is large, there can also be a significant cost if investors are missing months with good returns. For investors with long investment horizons, a simple buy-and-hold strategy appears more attractive than trying to time the market. 

You’ve done extensive cross-asset research on the importance of portfolio diversification. What are your key conclusions?

CMG: Broader diversification has usually improved risk-adjusted returns over longer time horizons. We find that adding non-U.S. equities might help improve returns on a US 60/40 portfolio from here – provided there is no bear market. At the same time, and in contrast to the last 30 years, we see little value in adding non-U.S. bonds given their low yields and exposure to rate-shock risk. Ultimately, there is no consistent “safe asset” or “hedge” across drawdowns because different assets protect against different types of shocks. Rather, we suggest a combination of strategies tailored to the source of potential shocks.

In addition to broader diversification, how else can investors most effectively reduce risk?

CMG: We’ve assessed several strategies to manage big unforeseen sell-offs in equities known as “tail risks.” While each strategy – which may rely on dynamic allocations or option overlays – has its shortcomings, they can complement each other and help improve the risk-adjusted returns of a diversified multi-asset portfolio. All of these strategies are worth exploring because at this point, improving the risk profile of a 60/40 portfolio seems more realistic than materially increasing returns.