Whenever we experience a spell in financial markets where high quality bonds lose value at the same time as equities a glut of commentaries appear either announcing the ‘death of the 60/40’, showing rising equity / bond correlations or proclaiming bonds have lost their diversifying properties. While part of this is usually an effort to sell alternatives, there also seems to be a genuine concern that bonds have evolved to develop a new set of characteristics. I find this puzzling – high quality bonds seem to be behaving just as we might expect them to. They are a good diversifier to equities but not a perfect one.

When bonds and equities lose money in unison there is almost always the same explanation – inflation. Bonds can offer strong protection from equity market risk when there is a growth shock (profits fall, but so do interest rates and inflation); they are not, however, a helpful equity diversifier when an inflationary problem arises (yields push higher and Central Banks are unable to cut rates).

This behaviour has always been a feature of how high quality (nominal) bonds act relative to equities in a portfolio. Very little has changed in that regard. All that has happened is that inflationary shocks have become far more common after decades where disinflationary pressure was the dominant trend.

This doesn’t mean that the relationship between equities and bonds doesn’t matter, it is just that it is important not to misdiagnose the problem. The real issue is that through a prolonged spell of subdued inflation, many investors became complacent about the role bonds play in a portfolio – neglecting the scenarios in which they might struggle.

Since we have experienced a succession of inflationary supply shocks through COVID, Russia-Ukraine and now the Iran conflict, these risks are now front and centre in our thinking. This has been coupled with a huge amount of angst about ‘fiscal sustainability’, which for countries who issue bonds only in a currency that they can also print (such as the UK and US) ultimately comes down to a question about future inflation.

These issues have led to bonds getting a very hard time.

It is worth reiterating that high quality bonds are a superior diversifying asset for portfolios where equities are the most prominent risk factor. Equities are a volatile asset class that can generate high long-term real returns, but are acutely vulnerable to weak growth and recessions. Bonds almost certainly diversify this risk better than any other option. This remains true today.

If an investor is considering reducing their allocation to bonds within their portfolio (which unsurprisingly more people seem keen to do at 5% yields than they did at 0%); it should not be because bonds no longer play a valuable role, but rather because they are attaching a higher probability to the occurrence of troublesome inflation.

This is a perfectly sensible view to hold, but we should remain cognisant of our propensity to exaggerate whatever risk is salient or fresh in our minds. The dangers of the availability heuristic notwithstanding, investors should be seeking to create portfolios that are well-balanced and resilient to a range of economic scenarios, including those in which equity and bond correlation is on the rise.

There are supplementary asset class options that might fill the gaps not covered by high quality bonds – inflation linked bonds, commodities and even trend following strategies. These choices are not unreasonable and a case can be made for their use in a diversified portfolio (alongside many other candidates). They all, however, come with weaknesses and require the acceptance of trade-offs (some very significant). Most importantly, none work as consistently well as a diversifier to equities in a growth downturn.

If we are in a world where the incidence of inflation shocks relative to growth shocks rises then we should expect a higher (average) correlation between equities and bonds, and probably some extra term premium (if inflation risk is greater, I want some additional compensation). This might impact portfolio allocation decisions, but I would be wary about our ability to anticipate future economic environments. I would be more confident in predicting that when the next recession arrives, we will all be glad to be holding high quality bonds in our portfolios.

Despite all the noise, bonds are behaving in just the way we should expect them to. It is probably fair to say that in an era of low inflation and falling yields investors didn’t make their portfolios sufficiently resilient to scenarios where bonds don’t complement equities as effectively. Yet this is the fault of investors, not the bonds. Making some adjustments to portfolios because of this oversight seems prudent, writing off bonds for performing in a perfectly predictable way far less so.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

Remarkably, it has been over a year since our last Decision Nerds podcast, but I am delighted to say that we are able to fill that yawning void in your life by releasing a new episode.

Inspired by one of the reasons for the pod’s absence, this episode looks at the problem of communication in the investment industry and why it is so difficult to do well. We cover:

– The curse of knowledge: Why explaining something you know to someone who doesn’t is so difficult.

– The dual audience problem: How to communicate to different people with different levels of knowledge in the same audience.

– The role of affect: How people react to communications is often dominated by how they feel (what we might call affect); considering the emotional impact of communication is often neglected.

As a bonus, you can also hear why I may never again read the detailed feedback on my own presentations.

You can listen here, and the episode is also available in the usual spots.

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This is not a piece about banal AI-written investment content, it is an exploration of why a reliance on AI kills the benefits of writing for both reader and author.

When I realise that I am reading a piece of writing that was AI-generated my heart sinks a little. In part this is because of the frustrating style it adopts with its incessant use of antithetical parallelism – “this is not just X, it is Y”. Yet there is something more important than this tedious rhetorical-tic: AI investment content strips all of the value and purpose out of the act of writing and reading.

Most investment writing (apart from generic, turn the handle market commentaries) should be thought of as a process which benefits both reader and author. The reader gets to understand the voice and views of the author, while the author can write as a way of shaping and developing their own thought processes.

If investment writing is just the result of a few prompts, it lacks any original thought and fails to represent the author’s voice. Rather it is simply the output of a predictive system that has no stake in what it generates.

For the author, high quality writing should never be merely an exercise in creating some form of content. Of course, writers are trying to communicate something, but the path to arriving at that communication is as important as the message itself. The process of writing involves exploration, reflection and refinement – all of this is lost if we simply rely on AI.

This loss is most pernicious for those with less experience or without true domain expertise. The process of writing to communicate is also an invaluable form of learning. When the answer is simply to ask an AI model to assume this responsibility for us, not only do we sacrifice the opportunity for slow, deliberative learning, but we also do not have the means or knowledge to question whatever answer AI provides. Writing is about so much more than the output.

Even if we do think only in terms of the end product, the loss from AI-reliance is pronounced. Readers know nothing about the person that (they think) might have written something. They have no sense of their voice, nor can they even provide feedback or challenge to the author, because it is not the author’s work.

Successful investment writing comes largely from a relationship of trust between reader and author that builds over time. As readers, we pay attention to the words and opinions of someone we might have followed for years, and we make judgements about the quality of views offered based on that trust. In a world where AI investment writing dominates, there is no trust, just an absence of it.

While the process of writing informs and enlightens both reader and author, writing can also act as a useful signal of expertise, effort and care. The friction that exists because good investment writing is difficult and complex evaporates when AI can churn out passable flannel in a few seconds.

It is possible to argue that the genuine, higher quality writing will shine through amidst the barrage of generic babble, but it will become increasingly difficult to find amongst the maelstrom of AI generated pieces.

AI writing will also inevitably get better and seem more authentic, so it will become harder to spot than it is now. This will not be a positive development.  As the quality of AI writing improves, the loss from our increasing reliance on it will become more pronounced. As more people turn to it, more of us will lose the benefits that stem from authentic, human writing.

There are, of course, aspects of the process of writing where AI can be incredibly helpful such as researching, fact checking (sometimes) and proof reading. It is also useful in producing the generic work that I imagine no human enjoys having to create, but in writing, and in general, we really need to start being very clear about what AI is good for and where its presence comes with a significant cost.

Investment writing should have a clear purpose and one that is more than simply attempting to communicate a certain message as quickly as possible. For many authors it will be a way of thinking through messy, subjective and complicated problems. While readers want to hear the trusted voice of a writer and understand what they are thinking and why.

All of the meaningful elements of investment writing are human, and most of these have very little to do with the simple production of content. As we increasingly rely on AI, we risk losing the manifold benefits that come from the process of writing and reading.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.

Although equity markets have thus far proved remarkably resilient in the face of geopolitical and economic risks, it is hard not to argue that we are in an environment of heightened uncertainty. Dispersion within equity markets has been extreme, asset prices are moving dramatically on a single tweet, and there is a daily torrent of erratic news flow. This is clearly a difficult backdrop for investors. Perhaps its most worrisome feature is the temptation to do two things we really shouldn’t.

What are these two things?

• Timing market movements.

• Concentrating our portfolios.

These are both usually bad ideas, but they are particularly pernicious in febrile financial markets. Unfortunately, our desire to undertake such actions seems to be strongest at the worst possible moments.

Time to Time

It seems odd that a reaction to rising market uncertainty is an increasing desire to predict how the market will move, but this is inescapably the case. We have an inherent discomfort with ambiguity, and by investing as if we know the future it can give us a sense of control. We can’t bear to sit and let markets happen to us.

To add to this, we are also loss averse. When people talk of market uncertainty what they really mean is that investors are worried that the chances of losing money are increasing. This is why most market timing behaviour is an attempt to get out of risky assets before a major fall, and then get back in at just the right time.

Trying to invest in such a fashion is a sure route to bad outcomes. Not only is the chance of us getting the initial timing correct incredibly low, but even if we are right we then need to keep making similar decisions. Getting in, and back out again. And what about next time? Do we try to repeat the trick every time we feel that markets are at a precarious point?

We have an incredibly strong instinct to act and to do ‘stuff’ – don’t just sit there, markets are moving! For investors that often means trying to make predictions about what happens next. While the urge to do this can feel irresistible, it flies in the face of the evidence about what is likely to work for us over time.

Lacking in Concentration

It is not just the temptation to trade and predict that arises during periods of heightened volatility and unpredictability – we are also likely to become more concentrated in our portfolios. If we see wide levels of dispersion across stocks, styles, asset classes or sectors, our instinct is to think: “Why am I owning these laggards? Why shouldn’t I focus on the winners?”

This is another form of market prediction, but in a different guise. When we see major performance dispersion in areas of the market (such as energy and software recently), and the compelling stories that are used to explain it, we can’t help but extrapolate. If this trend is going to go on forever, then all we need to do is focus on the right parts of the market.

Losing sight of the principles underpinning prudent diversification is a dangerous game, and can be extremely punitive in choppy markets where dispersion is wide. The cost of not holding certain assets or areas of the market can be heavy if we end up on the wrong side, which at some point we inevitably will.

The idea that diversification is a free lunch has always been a naive one, because it ignores the behavioural element. Being diversified means owning things that are performing poorly and that, in certain environments, we should expect to perform poorly. It is incredibly difficult for investors to embrace this idea – we just want to hold the good things that have been working.

Although I have framed market timing and concentration as distinct activities, they are – in essence – both a form of overconfidence in our ability to predict the future. It’s not that investors are gaining confidence as markets become ever more tricky to anticipate; it is rather that the sense of anxiety stemming from rising volatility makes us behave in ways that appear as if our confidence is on the rise.

Attempting to engage in more difficult activities as a reaction to a feeling that conditions are becoming increasingly challenging is an odd and costly path, but a very human one.

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The sense that markets are unusually uncertain is the time when behavioural discipline matters most, but also when we are highly likely to abandon it. Market timing and portfolio concentration feel right, but really they are just the easy options that make us feel good, while being very unlikely to work.

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My first book has been published. The Intelligent Fund Investor explores the beliefs and behaviours that lead investors astray, and shows how we can make better decisions. You can get a copy here (UK) or here (US).

All opinions are my own, not that of my employer or anybody else. I am often wrong, and my future self will disagree with my present self at some point. Not investment advice.