For the first time since the 1970s, investors are confronted with international conflicts that have a fundamental impact on financial markets, primarily through their effect on inflation and interest rates, which are likely to remain higher for longer (as discussed in a previous issue of Dasym Horizons).

To deal with the high level of geopolitical risk, which could escalate into a world war-like scenario, investors should think about how to deal with escalations of international conflicts. As we have discussed, reducing exposure to China or overweighting exposure to the US carries significant risks. Instead, investors should consider alternative strategies.

One such alternative strategy is to make tactical shifts in portfolios by reducing bond exposure and reallocating to hedge funds or commodity long/short funds. This tactical allocation, however, should not be applied to stocks.

Examining the daily returns of the S&P500 Total Return Index (ticker SPXT) over the past two decades, covering approximately 5,000 trading days, reveals a key lesson: missing the best trading days in stocks has a significant impact on realized returns. In addition, these best trading days often occur after periods of significant stock market losses, making market timing even more difficult. Therefore, investors should stay invested in stocks and maintain a constant exposure.

As the graph below shows, staying fully invested over this 20-year period would have resulted in an annualized return of 9.8% in U.S. dollars. However, missing only the top 10 trading days would reduce returns to 5.6%, while missing the top 20 days would yield only 3.0% per year. Missing the top 30 trading days, which represent less than 1% of all trading days, would result in only a small positive return (+0.8%).

Performing a similar analysis for bonds, focusing on the Bloomberg USAgg Index (ticker LBUSTRUU), which includes investment-grade government and corporate bonds, leads to a different conclusion.

Unlike stocks, missing the best trading days for bonds doesn't have much of an impact on performance. Over a 20-year period, an investor would have yielded a 3.0% annualized return when fully invested. However, missing the best 10, 20, and 30 trading days would result in annualized returns of 2.3%, 1.8%, and 1.4%, respectively.

Because bonds have a less skewed distribution of daily returns for bonds, they appear to be more amenable to tactical shifts in portfolio weights. This underscores an important lesson: while investing in stocks should be primarily strategic, investing in bonds can afford more tactical adjustments.

This finding opens up opportunities for investors to adjust portfolio weights to bonds during times of high uncertainty. For example, if one of the international conflicts escalates significantly, one might consider shifting out of bonds and increasing tactical exposure to alternative investments (like hedge funds or commodity long/short funds).