Photo: Todd Martin
GMO’s outlook for both stocks and bonds is that returns will be disappointing for years to come.Given these assumptions, Robert Huebscher of Advisor Perspectives wrote an article titled GMO: Two Questions We Can’t Answer.
In it, Ben Inker, GMO’s head of asset allocation, tackles two questions that Huebscher thought would be unanswerable for the asset management firm.
1. What role should bonds play in a portfolio?
Diversification: “Inker said that investors are overestimating the value of bonds’ risk reduction. In the past several years, he said, the correlation between stocks and bonds has been starkly negative. GMO thinks that extreme lack of correlation is unlikely to persist.”
Hedge Against Deflation: “The problem, Inker said, is that yields these days are too low. The potential return from, for example, a 10-year bond going from 2% to 1% is not offset by the risk of loss of capital if yields increase from 2% to 3%.”
With GMO foreseeing more correlation between stocks and bonds, along with how bonds are not perfect hedges against deflation, the question regarding what role bonds should play in a portfolio does not seem unanswerable. Rather, we just need to rethink what we already assume about bonds.
2. Should investors be overweight stocks just because bonds are unattractive?
“The danger, Inker said, is that stocks might quickly go from modestly overvalued to fair value, in which case investors would suffer a permanent impairment of capital. “That scares us,” he said – unlike the situation in the winter of 2009, when bonds were priced similarly to how they are today, but stocks were clearly undervalued.”
“Inker said his discomfort lies with the notion that investors should increase their overall portfolio risk simply because they are being offered a bad opportunity set.”
Again, this is another question that does not seem unanswerable. Rather, GMO’s position is that you shouldn’t just jump from one conclusion to another without considering the risks.
In Inker’s mind, equities are indeed the best asset class available, but the high risk nature of the market worries him. Meanwhile, bonds are unattractive, but should you buy stocks just because of that? GMO cannot seem to find an accurate answer to this difficult question.
For now, their way of addressing these risks is to hold more cash. But that isn’t without its own risks.
A key reason Inker likes cash now is because of its “option value” – money remains available until other assets become cheaper. This opportunity value may trump the near-zero yields cash offers now.
Of course, there is an opportunity cost to cash as well, Inker said. If no cheap asset classes emerge, then investors will endure negative real yields in cash. Indeed, if asset classes are at fair value, the option value of cash is worthless.
Read the whole article at AdvisorPerspectives.com >
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