Technically Speaking: Importance Of Duration Matching

Technically Speaking: Importance Of Duration Matching

by Lance Roberts, Real Investment Advice

I am going to take a little deviation from the normal "technical update" to discuss an issue that is very important, and always overlooked, by mainstream analysis - "duration."

In the bond market the concept of "duration matching" is commonplace. If I have a specific target date 10-years in the future, I don't want a portfolio of bonds maturing in 20-years. By matching the duration of the bond portfolio to my target date, I can immunize the portfolio against increases in interest rates which would negatively affect the principal value in the future.

Unfortunately, in the equity markets, and particularly given the advice of the vast majority of mainstream analysis suggesting that all individuals should "buy and hold" indexed based investments over the long-term, this concept is disregarded.

However, it is a crucially important concept to understand and incorporate in the portfolio and risk-management process. Let me explain.

Over the years, I have done hundreds of seminars discussing how economic, fundamental and market dynamics drive future outcomes. At each one of these events, I always take a poll asking participants how long they have from today until retirement. Not surprisingly, the average is about 15 years.

The reason is obvious. For most in their 20's and 30's, they are simply not making enough money yet to save aggressively nor or is that a focus. During the 30's and early 40's, it is buying a house, raising kids, and paying for college - again, not a lot of money left over to save. For most, it is the mid-40's and early 50's where the realization to save and invest for retirement becomes a priority. Not surprisingly, this is the dynamic that we see across most of the country today in survey's showing the majority of individuals VASTLY under-saved for retirement.

Chart Courtesy Of Motley Fool

median-net-worth-by-age_large

As you can see, $45,000 to fund retirement isn't going to cut it.

Bare with me, I am getting to the point.

Let's make a couple of assumptions. First, you don't have 100+ years to invest in the market to get the "average" long-term returns unless you have contracted "vampirism" during your recent visit to Transylvania.

Second, your "long-term" investment horizon is simply the time you have between today and when you retire. As I stated above, for most that is about 15 years.

So, for argument sake, let's assume you have 20-years from today until retirement. What we do know is that based on current valuations in the market, forward real returns in the market will likely be, on average, fairly low to negative.

SP500-Real-RollingReturns-20-Years-051916

What this chart clearly shows is the "WHEN" you invest is crucially more important than "IF" you invest in the financial markets.

This is where the concept of "Duration Matching" in equity portfolios become important. The chart below shows the long-term market broken down my full-market cycles.

SP500-PE-Real-LongTerm-051016

Given a 15 to 20-year time horizon for most individuals, investing when market valuations were elevated resulted in a loss of principal value during the time frame heading into retirement. In other words, most individuals simply "ran out of time" to reach their retirement goals. This has been the case currently for those 15-20 years ago that were planning to retire currently. Those plans have now been permanently postponed.

Matching Duration

When I build a portfolio model, I make sure an take into consideration the actual "time-frame" to retirement. For example, for an individual with a 15-year time frame to retirement a portfolio model would resemble the following:

Portfolio-Model-051016

The portfolio is designed to deliver a "total return" including capital appreciation to adjust the value of the individual's "savings" for inflation, interest income and dividend yield. Each of these components is critical to achieving long-term invest success. However, while we can build a portfolio of bonds with a specific maturing, we have no such option in equities. This is where "risk management" must be used as a substitute.

Let's compare the portfolio above with an all-equity portfolio in a market environment that is either +/- 10% in a given year.

Assume: Equity delivers a 2% dividend yield and taxable bonds deliver 3% in interest income.

Portfolio-Model-Returns-051016-2

As you can see, managing a portfolio against downside capture can greatly increase future outcomes of the time frame an individual has until retirement. As you are aware, I have been posting a model in the weekly newsletter since 2007 which adjusts a 60/40 allocation model for risk. By reducing the amount of time required to "get back to even" long-term returns can be improved to reach projected retirement goals.

Portfolio-Model-Returns-051016-3

Disclaimer: All information contained in this article is for informational and educational purposes only. Past performance is not indicative of future results. This is not a solicitation to buy or sell any securities. Use at your own risk and peril. No recommendations are being made or suggested.

Managing Risk

With the understanding of the long-term market dynamics, and the realization you will not likely live forever, in mind we can discuss using the technical backdrop of the markets currently as it relates to portfolio risk management.

In the short-term, market dynamics have improved enough at this point to warrant the increase in exposure that I discussed several weeks ago. As I stated in this past weekend's newsletter:

"With the market defending the 50-dma on Friday, combined with the short-term oversold condition, a bounce early next week is likely.

However, this does not mean the markets are ready to go soaring back to new highs. As shown these bounces can, and have been, very short-lived in many cases.

The bounce on Friday was also important as the market defended the 400-day moving average as well. Just as I showed above, the combined defense of support at the 400-dma with an oversold condition suggests that markets are set up for at least a short-term bullish advance."

SP500-Chart4-050616

While short-term dynamics have improved, including a positive advance in the advance-decline line, an upturn in investor sentiment, and the number of stocks trading above their respective 200-day moving averages, a step back to a longer-term picture still warrants caution.

By using a MONTHLY chart, below, we can gain a better perspective of the current market trends and dynamics. As shown, while the short-term dynamics of the market have improved, the long-term trend is still negative from previous market highs. Combined with negative divergences in momentum, relative strength and price trends, as well as the fundamental backdrop of earnings deterioration, there is certainly significant rational for remaining more cautious in portfolio allocations.

SP500-MarketUpdate-051016

Should you invest in the markets? Yes.

If you are 20-years old, then buy an index fund and dollar cost average into and never look back.

If you are 45-years, or older, and are staring retirement in the face, with valuations elevated, fundamental and economic prospects weak, and the majority of the previous bull-market behind you; managing your portfolio as if you were a 20-year old may have significantly negative outcomes.

As I stated above, the problem with equities is that never mature. Unlike bonds where a specific rate of return can be calculated at the time of purchase, we can only guess at the future outcome of an equity related investment. This is why some form of a "risk management" process must be adopted particularly in the latter years of the savings and accumulation time frame.

While it is always exhilarating to chase markets when they are rising, cheered on by the repetitious droning of the "buy and hold" crowd, when markets reverse those cheers turn to excuses. You are likely familiar with "no one could have seen the crash coming" and "you're a long-term investor, right?"

The problem is that the long-term of the market and the long-term of your retirement goals are always two VERY different things.

There is only one true fact to remember:

"All bull markets last until they are over." - Jim Dines

Lance Robertslance_sig

Lance Roberts is a Chief Portfolio Strategist/Economist for Clarity Financial. He is also the host of "The Lance Roberts Show" and Chief Editor of the "Real Investment Advice" website and author of "Real Investment Daily" blog and "Real Investment Report". Follow Lance on Facebook, Twitter, and Linked-In

 

Copyright (c) Real Investment Advice

Total
0
Shares
Previous Article

3 ways your retirement will be different from your parents’

Next Article

GMO: Investment Outlook (May 2016)

Related Posts
Subscribe to AdvisorAnalyst.com notifications
Watch. Listen. Read. Raise your average.