Conservative investor's needs were once met by a portfolio of bonds.
These investors did not have to worry about the volatility of stocks because their portfolios were immune to the inherent, and sometimes severe, gyrations of the stock market. When interest rates were higher, conservative investors could safely own a portfolio of long-term bonds earning 5% to 7% and feel secure that the “income” generated was enough to meet their needs.
In today’s economic environment, things are quite different. Interest rates have been quite low, and rates of 5% to 7% have not been available for years. The benchmark often used for interest rates is the 10-year U.S. Treasury Note. The last time the 10-year U.S. Treasury rate was 5% was mid-2007. The last time the rate was above 6% was June of 2000. The last time this rate was over 7% was 1995! Investing in a low interest rate environment can be a challenge, and this environment has lasted far longer than many anticipated. This is especially troubling for the conservative investor.
Why is the focus on return so important?
Every investor has a “required” rate of return, that is, a rate they need to achieve their goals. Their portfolio must grow by this rate in order to maintain their lifestyle. While the needed rate varies widely depending on their situation, most investors need returns in excess of inflation (historically, 3%) to keep pace with the increasing cost of their goals.
Inflation is a vital concept to understand in the world of investing because it is a risk we all face. As inflation rises, every dollar will buy less of a good. For example, if the inflation rate is 3%, then a car costing $30,000 this year will cost $30,900 next year. So, if your rate of return is not keeping pace with inflation, the purchasing power of your investments is reduced.
The issue with bonds today is that interest rates remain at these historic lows. As of this writing, the 10-year Treasury is approximately 2%. To put this in context, if you were to buy a 10-year Treasury note today, the investment would not keep pace with expected inflation and, in ten years, you conceivably will have less purchasing power. A similar dynamic is happening with short-term rates. Money markets, CDs, and other traditional cash-equivalent investments are paying close to 0%, but prices continue to rise. So, cash held in an emergency fund, as we and many advisors recommend, is earning virtually nothing.
What is an investor to do?
As we all know, there are three basic investment opportunities: cash, bonds, and stocks. Considering the historic low rates noted above, bonds and cash are not yielding enough to sustain most lifestyles.
In trying to avoid the stock market, some investors have tried to increase their rate of return by investing in higher-yielding, lower-rated bonds because they offer a potentially higher return. We fear that many of the investors flocking to high-yield, i.e., junk bonds, are unaware that they are taking stock-like risks with their bond portfolios. Many unsuspecting investors have been hurt by junk-bond losses in prior decades.
This leaves investors with a need to seek the higher returns of stocks. Historic returns on the stock market have been in the 8% to 10% range, so one would imagine this type of return, while attractive, comes at a price. That price is a higher degree of uncertainty than that of traditional bonds. This means a higher degree of volatility, a higher degree of portfolio fluctuations, and, consequently, a higher degree of stress.
Higher risk investments, while having a high expected average return, can also be expected to have a wider range of outcomes and more volatile returns. The higher risk investments are also likely to experience significant losses from time to time. Those who have historically invested in the more stable bond market are not accustomed to significant losses.
Riding it out
Older investors, whose parents “grew up” and retired comfortably on a portfolio of fixed-income investments, have been “forced” into stocks and have experienced short-term portfolio losses a few times during the past 15 years. They have lived through the tech bubble in 2000-2002, the financial crisis in 2008, and the downgrading of U.S. debt in 2011. Some who find it more and more difficult to live with these gyrations may have abandoned stocks altogether. In our experience, they do so at their own peril. We have seen the results of clients who have become too conservative; they have foregone higher returns because they could not stomach some short-term volatility, despite reams of evidence illustrating a well-diversified portfolio has proven to show positive returns over the long- term. Their nest eggs are losing their purchasing power even as they appear stable.
This phenomenon can be extremely disconcerting for the more conservative investor, especially if this investor is also facing monthly distributions. The combination of short-term losses and regular distributions will exaggerate the short-term losses, providing a shock when viewing a monthly statement. Because many individuals tend to focus on short-term results, the portfolio losses are frustrating and troubling even though they may have followed a period of significantly positive results. Monthly statements are a good indication of your asset level, but they do not provide a good indication of performance nor do they provide a long-term probability of success.
Behavioral finance has shown that we all react more strongly to losses than we do toward gains. This is more acute in some people despite empirical evidence that long-term results tend to be positive. Investment theory and historical market returns indicate a relationship between the level of investment risk and the level and range of returns that can be expected. To achieve a higher expected return, one must accept a wider range of possible results from month to month.
Comprehensive financial planning is so much more than investments, and the “noise” generated by the business entertainment industry can make it difficult to see the big picture. We cannot let this information be a distraction and allow us to lose focus on the main goal.
The proliferation of media coverage of such formerly esoteric data such as monthly employment rates, quarterly earnings reports, weekly unemployment claims, etc., makes the task of focusing on an individual’s plan much more difficult. All of this “noise” can make it challenging to move the conversation away from investments. Unfortunately, we see no end in sight.
Interest rates will likely remain low for a few more years, and until they return to levels that can sustain a person’s lifestyle, investors are left with little choice but to create a strategy that accepts this new reality. Ignoring the reality and chasing the latest “hot” investment is not a viable strategy. We understand how frustrating this is, but we remain committed to the academic research that shows a well-allocated portfolio provides the best probability of beating inflation over time.
When interest rates revert to levels that are in line with or higher than expected inflation, a portfolio with a greater percentage of bonds and less stock exposure may produce enough expected returns to meet our client’s goals. Until that time, it is prudent to invest in a diversified portfolio with expected returns that match their required return.
As always, seek professional advice from your comprehensive financial planner before taking advice from the internet. For more information about HIGHLAND Financial Advisors, click here, or sign up for our newsletter below to get our updated articles.