Key Points.
- A portfolio’s return matters. How much risk was taken to achieve it matters equally.
- Short-term US treasuries produce income, preserve capital, and create a ready reserve when equity prices fall.
- Portfolios with a cash and treasury buffer decline less when markets fall; the buffer funds the purchase of great businesses at lower prices.
- When the markets rise, the portion of the portfolio held in shares rises, while taking less risk.
Imagine two investors sitting on identical portfolios the day markets drop 20%. One watches the value fall and waits. The other watches the value fall less, and starts buying.
In this article, we examine the role of a risk management buffer in a portfolio.
What Makes up a Portfolio?
A portfolio is a collection of ownership stakes in real businesses. When you hold shares in a company, you hold a fractional claim on its earnings, its assets, and its future cash generation. The price of those shares moves daily, mostly for reasons entirely unrelated to it. Markets are driven by sentiment and liquidity.
This means that even a portfolio of excellent businesses will fluctuate in value. That fluctuation is not a flaw but rather the nature of liquid, publicly traded assets. The question for any serious investor is not how to eliminate fluctuation, but how to structure a portfolio so that fluctuation becomes an opportunity.
The Role of Short-Term Treasuries.
A short-term US treasury is a loan made to the United States government, repaid in full within twelve months or less. The government pays interest for the use of that money. The capital does not fluctuate. The income is predictable. This is what is known as a “risk free” asset.
In a portfolio context, a short-term treasury holding serves a precise purpose. When equity markets are fairly valued or expensive, it provides risk mitigation against the “risk on” sentiment. It does not fall when sentiment changes. And when equity prices drop to levels that represent genuine value, we have the option to sell treasury holdings to buy great companies at low prices.
What Happens When Markets Fall.
Consider a portfolio with $500,000 in total value, annualising at 10% since inception. Roughly one-third, approximately $165,000, is held in cash and short-term treasuries. The remaining 70% is invested in equities.
If equity markets fall 20%, the equity portion of this portfolio declines by approximately $67,000. The treasury and cash portion does not. The portfolio as a whole falls by roughly 13% rather than 20%. The gap between those two numbers is seven percentage points of preserved capital.
More important than what is preserved is what becomes possible. The $165,000 held in treasuries remains intact and deployable. Great businesses are now available at prices 20% lower than they were. The investor who held no buffer must watch and wait while the investor with the buffer can act.
What Happens When Markets Rise.
When markets rise, risk increases. The longer “risk on” sentiment prevails, the riskier the market becomes.
A portfolio that returned 13% annualised while carrying 30% of its assets in short term treasuries has not underperformed the market on a risk adjusted basis, where the market returned 15%. To determine the risk adjusted return, one would divide 13% return, by 0.7 to reflect the 30% of assets held in short term treasuries. Therefore, the return of the equity portion of the portfolio is 18.6% relative to the market return of 15%.
This demonstrates that meaningful returns are achievable without investing the full portfolio in equities during times of increasing risk.
At AXIAM, the short-term treasury position is an active tool. We keep dry powder to purchase equities when markets are less risky.
End.