FIVE THINGS YOU SHOULD KNOW
INSIGHTS for INVESTORS
Intro – The New Reality
Explaining and helping clients navigate trade-offs is one of our most important jobs. It could be with regards to their plans and prioritizing how they’ll spend and save, or it could pertain to their portfolios and the continual balance between risk and reward.
Today’s investors have tougher trade-off than have existed in some time for two big reasons: interest rate levels are lower and inflation rates are higher than they’ve been in 30 years.
People who wisely choose to tackle these challenges head on should know they are still “damned” compared to prior eras in that they will have to accept more volatility than when bonds provided strong yields and volatility protection.
HOWEVER, those who choose to stay with classic allocations/approaches and/or hold too much cash are “double damned” as they will likely not only deal with volatility, but they will experience real losses from both continued negative returns on bonds from rising interest rates and reduced purchasing power from much higher inflation than we’ve seen in decades.
The Risks of Failing to Evolve
The prudence of “staying the course” as an investor is critical when facing the emotional challenges associated with volatility and making emotional decisions, but is a recipe for disaster when applied to definable changes in the investing landscape. Such a truth is why one wouldn’t want to just hold individual stocks indefinitely – times change (e.g. Sears and Kodak vs. Amazon and Apple). The same goes for fixed income these days – what has worked to date is unlikely to work going forward.
Why is this so important? Portfolio Longevity
We touched on this challenge before, and it was highlighted again by Allen Roth of Wealth Logic who recently stated, “My modeling shows a 3% spend rate is good for about 25 years and life expectancies have dramatically increased. So perhaps a 65-year-old couple should use something like a 2%-2.5% spend rate if their spending is all non-discretionary. A younger client would spend even less, but an 85-year old client can spend far more.”
Legendary bond manager Bill Gross, has been sounding the alarm as well, going on record stating, “…markets have likely seen their secular, long term lows in interest rates but expectations for a 30-year bear market to match the previous 30-year bull market are way overdone. The 10-year Treasury now at 1.60% is likely headed to 2% over the next 12 months which is bearish and likely to provide a negative sign in front of 2022 total returns for bond holders.” Note, traditional bond holders are down approximately 2% this year, which coupled with stated inflation means they’ve really lost around 6-7% in purchasing power.
The following chart comes from JPMorgan’s Quarterly Guide to the Markets and shows how a rise of just 1% could lead to significant losses for bond holders.
Numbers in this chart is why, despite agreeing with the danger in general, I think Roth’s modeling might actually be optimistic as yields, while likely to rise over the short term, are still going to remain low in the longer term (vis a vis recent history) and inflation is likely to continue to destroy purchasing power for some time.
Some Solutions to the Challenge
A. Embrace Volatility
Standing on the shore, e.g., holding cash or traditional fixed income, is no longer an option to reach your goals/destination. We need to get in the boat, accept there will be weather and waves, but with the right boat (e.g., portfolio) we can safely reach the other side.
Volatility isn’t fatal, but permanent loss, whether relative (inflation) or absolute, can be to the longevity of one’s portfolio.
Volatility can often feel like risk, but in those times remind yourself of what you are really afraid of.
B. Look to New Asset Classes and Strategies
Some believe the answer, or perhaps their only alternative is to buy more equity exposure. While this may be true to a degree, extending one’s risk profile too far in this manner has its own issues – from corresponding volatility levels that increase one’s odds of panic selling, to current valuations that may lead to below average returns and/or liquidity risks which may arise from unexpected day to day expenses in one’s life.
In short, we still believe in diversification, and the good news is there is much more to the world than the S&P 500 and its holdings, such as those found in Barclay’s Aggregate bond index.
Alternative assets classes such as private credit, real estate, or alternative portfolio strategies such as call writing or market neutral approaches can be of great utility in today’s environment.
For one thing, they all help increase income, which can be created from a portfolio, meaning more money for you to safely spend without bringing sequence of return risk to your portfolio.
Another key benefit is that these types of holdings have historically not only performed better on a relative basis than traditional fixed income, but they have also actually posted solidly positive returns. Of course, past performance doesn’t guarantee future returns, but it would strongly suggest bonds are unlikely to do well (Chart #1) and well assets like private real estate (Chart #2) and market neutral strategies (Chart #3) have a high probability of faring well.
The following chart (#3) reflects a market neutral strategy (that we are intentionally leaving unnamed for compliance purposes) that we use and how it has fared (blue bars) vs. the Bloomberg Barclay’s Bond index (green bars) during periods where Treasury yields rose more than 100 basis points.
Chart # 3
Today’s investors no longer get to count on traditional bonds as a solid source of both yield and volatility protection. In fact, for the time being they have, and are likely to continue to be a source of loss.
However, for investors who understand avoiding true risk (i.e., permanent loss) requires change, some new approaches and perhaps, the acceptance of more volatility (i.e., temporary loss), there are plenty of attractive options.
Yes, today’s environment is challenging – but don’t let what’s worked before, or your fear of change keep you from taking some simple steps to keep you on track to achieve your goals.
Have a great weekend,
Tim and the team at TEN Capital