THE BOND COMPONENT IN A PORTFOLIO: THE IMPORTANCE TO HAVE A RESERVE AND HOW TO USE IT

THE BOND COMPONENT IN A PORTFOLIO: THE IMPORTANCE TO HAVE A RESERVE AND HOW TO USE IT

Every portfolio has a bond component which permits to balance the risk involved in any investment. Depending on the size of the portfolio and the risk level of the investor, the bond component may vary from 0% for very aggressive investors to 50% for very conservative investors. This may also vary according to the market expectations where one will be hold less bonds when the market level is low and more bonds when it is high.

But what is of interest is how to use this bond component effectively if we want to boost our portfolio's return. The starting point of this is to see the bond component of the portfolio as a reserve which could be committed at any time to buy stocks when the conditions are favorable or are dictating such a move.

A reserve in a portfolio is the bond component which is not initially committed to the investment in a stock or a group of stocks by the portfolio manager. Thus it is available to address unexpected situations or exploit the investment opportunities that develop suddenly. The portfolio manager can hold it back in order to deal with an adverse situation or to commit it in an investment operation when such an opportunity arises.

It is often better to have some uncommitted liquid money or almost liquid asset (bond) to deal with adverse situations or favorable opportunities. It is sometimes very difficult to liquidate a position in order to meet an unexpected situation whether favorable or unfavorable. This can cause a disrupt in the portfolio's structure which in turn may affect adversely its return. By using this uncommitted reserve, the portfolio manager could preserve the current investment positions and quickly move to stabilize a weak exposure or to exploit a favorable investment opportunity.

The portfolio manager's decision as to when, where and how to employ the reserve is extremely important. Usually the portfolio manager should use a portion of the reserve at the given moment and time since it will be sufficient to fulfill the objective. But committing the reserve in its entirety at once can only be considered in extreme cases. In the event that the portfolio manager wants to exploit an investment opportunity by committing the reserve, a portion of it should be held back in order to exploit unforeseen events. In case that the reserve is substantial, it can be used all together to deal with new strategic situations or investing in a suddenly depressed blue chip.

Here is an example:

In the first quarter of 2009, the ISE had dropped to 20000 from its peak of 60000 (November 2007) and the consulting company I was working for saw the stock component of its investment portfolio drop more than the market itself. But the bond portfolio was unharmed and represented, at the time, 75% of the portfolio. As the market had hit rock bottom, I proposed to the management the following investment plan:

In the first phase, the stock component would be restructured by selling all the stocks except two of them. Then the proceed would be kept in the repo until an opportunity arises.

In the second phase, with the upcoming of the opportunity, the money stationed in the repo and the bond component would be merged to form a general reserve which would be used to invest in stocks.

In the third phase,  the general reserve would be invested in 10 stocks in total but TL equal weighted once the risk level of the market becomes meaningless.

The opportunity came on 23032009 and the portfolio was invested altogether into 10 stocks and the former 2 stocks that were present in the portfolio were first sold and the proceed was passed to the general reserve. The overall performance of the portfolio until November 2010 was 280% whereas the stock market's return was 200% (when the investment had been undertaken, the market stood at 23000 and when the portfolio was sold, it stood at 70000)...