If one lesson was learned last week it should have been that a sound and sensible portfolio is usually well diversified.
That is not just a consideration for the “bond book” or the “equity book” that separate, yet under-one-roof fund managers run. It is the case for their combined books, i.e. the total balance of exposure that any asset manager operates.
Any well-managed investment portfolio should be constructed according to certain pre-defined parameters. These may specify a minimum credit rating, a maximum maturity or duration. Maybe there is to be a minimum spread over the curve, issue size to ensure liquidity, a limit on the investment price relative to par and perhaps where a security is listed.
The parameters that define a portfolio 
Source: Spotlight Ideas
The diagram above marks the parameters of what is acceptable at a given time for a theoretical fund or portfolio manager to invest in. Inside or on the parameter line (black) is acceptable; outside is not.
A fund manager’s dilemma
At the present time it feels as if interest rates are at or near a bottom. That would suggest that rates will either stay at the current levels or begin to rise. However, we must not make the error of believing that this low level dictates the next direction will be higher. With the International Monetary Fund having delivered a somewhat gloomy assessment of the global economic outlook, rates could well drop further.
One only has to look back to the start of this year to recall that in January, 97% of the market economists/bond analysts surveyed by Bloomberg said that bond market interest rates would rise by the end of June. Indeed by April, the other 3% had caved; only a few independent analysts said otherwise. 
Source: Financial Times, Spotlight Ideas
As one can see, the 10-year yield for the government bonds of the US, Germany and the UK have all followed a downward path.
To support the fact that low yields do not herald an immediate rise and hence a price decline, one only has to look at recent auctions of sovereign debt. Paper is well placed as the macroeconomic trend implies that despite the ultra-accommodative stance of the central banks, there is no runaway inflationary pressure. In fact in the Eurozone, the path is more toward one of deflation.
That case does not yet apply to the US or UK and both nations are pleased to see prices increasingly near the 2% target and unemployment rates falling to 6% or under.
If it is so good for bonds … why buy equities?
The turbulence of last week has passed and in the first two trading sessions of this third week in October the cash flow is back to equities once again. Even though the few trading sessions were marked by rising volatility, there was never any episode of outright panic selling. More interviews on the various financial television channels such as Saxo TV featured equity analysts who suggested the dips actually opened new buying opportunities.
Psychologists have observed that when making risky decisions, especially when volatility is running high, investors, be they individuals or institutions, are particularly wary of incurring a loss. In general, a flaw with many investors (mostly at the individual level) is that if the cost is greater than the prevailing market bid they will not sell as a loss would be incurred. The only situation whereby a sale will be made is if it is forced upon the investor by an enforced shift in the portfolio parameter or by exogenous liquidity demands.
Asset bubbles are notoriously difficult to spot so a well-disciplined approach to managing investment portfolios that uses defined parameters is essential. Photo: Thinkstock
Two psychologists – Daniel Kahneman and Amos Tversky – identified this phenomenon as “Prospect Theory”. It is a behavioural economic concept describing the way people choose between probabilistic alternatives that involve risk, where people make decisions based on the potential value of losses and gains and that people evaluate these losses and gains using certain heuristics.
That said, professional asset managers frequently show a disciplined approach by staying with well-researched economic assessment and acting when stop losses, profit protection or upside targets are activated and/or attained. In judging the economy, the sentiment is that there is belief that the Federal Reserve Bank under chair Janet Yellen is in control and will not act too fast or too slowly.
What of market bubbles?
“Bubbles being difficult to spot” is an understatement. Many investors get carried away with the superficial notion that as “the trend is their friend”, asset values will continue up in a straight line. That is not the case; even within a generally bullish phase for say equity prices, there is rotation inside the overall impulsive channel. (In a bear market corrective channel the same rotation can be seen). 
Sources: Financial Times, Spotlight Ideas
Since the close last week on Friday October 17, the S&P 500 has added 54.22 points from 1886.76 to 1941.28, or 2.89%.
Of course, at any time interest rates are acting as if inside a submarine, i.e. well below the surface of what we would consider the normal place of rate habitation, it can be argued that soft rates have led to elevated asset levels. One could argue that margin debt facilities used to buy financial assets have found ready consumers as they believed Fed policies would continue to drive up equity prices.
Yellen will of course be aware that any suggestion that she is about to snatch away the punch bowl could signal an end to the equity index rally. As a Fed watcher, I accept that Yellen will be acutely aware of the responsibility the central bank has to the US economy and to the world: it is the one central bank that can still set the tone and tenor for the rest of us.
Sudden shifts in policy can be damaging … as I continue to stress, just look at the repercussions felt in emerging markets from Argentina, to Turkey to Indonesia.
If investors anticipate higher returns in the US, they will move their investment capital money out of riskier overseas investments. If they sense that disinflation in the Eurozone will turn to deflation, then high grade, liquid bonds such as Germany and France (despite all the problems in the Fifth Republic) will continue to perform well while periphery paper could blow out, for example, Greece last week.
It is clear that in this complicated and interlinked world, a well-reasoned attitude toward diversification based on established risk boundaries and trade will foster consistent returns in tune with the prevailing economic fortunes.