by Craig D. Price, Certified Financial Planner®, CTFA and Will Thompson, Certified Financial Planner®, Certified Financial Advisor®, Stuart, Florida.
Since Donald Trump’s election, the stock market has soared to new highs while interest rates rapidly increased, causing a resulting decrease in bond prices. The decline in bond prices has understandably caused concern among investors.
We’ve received calls from many of our wealth management clients here in Stuart, Florida. What comes to your mind when you think about investing in bonds? Are safety and stability your first thoughts?
The below graph shows the annual return for the 10-Year Treasury Bond from 1926 through 2015.
Are you surprised by how volatile the returns have been? Despite this volatility (or maybe because of it), the 10-Year Treasury returned 4.96% on average (the orange line) with an astounding 32.81% return in 1982. Sixteen of the 88 years had negative returns, about 18% of the years. The largest loss was 11.12% in 2009. Only 12 of the 88 years did Treasuries return within ±1% of the 4.96% average. You probably expect and accept volatility for stock prices, but volatility is the norm for even seemingly stable bonds.
Benjamin Franklin wrote “In this world nothing can be said to be certain, except death and taxes.” He missed one. Volatility of investment returns is also certain. Volatility and potential losses are the price investors pay for maintaining and possibility improving their lifestyle.
Studies have shown that, on average, humans feel regret from losses two- to two-and-a-half times more strongly than they feel pleasure from similar-sized gains. Researchers have named this phenomenon Loss Aversion. Markets have positive expected returns over time, but these returns gyrate unpredictably. So, the longer the interval, the higher the probability of gain. The more frequently we evaluate our portfolios, the more likely we are to see losses and hence suffer loss aversion. Loss aversion can cause investors to act in ways that are less than optimal. Inversely, the less frequently investors evaluate their portfolios, the more likely they are to see gains. Accordingly, we encourage investors not to place too much emphasis on monthly returns. For long-dated goals, we even de-emphasize yearly returns.
A glance at the table on the right shows that the probability of the S&P 500 generating a gain or a loss in the very short term is close to 50-50. Monthly returns are positive just over 50% of the time. Positive utility – to experience more pleasure than pain – requires a holding period of nearly one year. Thus, closely following your monthly statement is not likely to make you any happier.
Interest rates consist of two components: expectations for inflation and economic growth. Both require macro-economic forecasts. Macro-economic forecast based investing is not something we practice at Price Wealth Management (few have succeeded though many have tried). Did you correctly foresee how the presidential election would impact interest rates? Will you be able to foresee the next macro event? By changing your portfolio based on macro events, you are implicitly saying you will.
There is no app you can download that will automatically help you then markets move against you. The best you can do is build a sensible portfolio and then accept that adverse moves will only be temporary, they can’t be successfully avoided (though many snake oil salesman will claim they can), and you will come through the downturn just fine.
If you cannot maintain a long-term perspective for your bond investments, you have several alternatives.
- Sell Your Bond Investments and Remain in Cash.
But even this entails risks. How will you feel when you miss out on the bond market’s return? Will you feel regret? With inflation nearly certain, holding cash means you are nearly certain to lose your current purchasing power. How will you feel if your lifestyle is eroded?
- Exchange Fixed Interest Rate Bonds for Floating Interest Rate Bonds.
This will mute volatility (though not eliminate it). However, it will come at the expense of appreciation potential and low yields offered reflect the reduced volatility.
- Hedge the Exposure
Hedging is expensive. Is it worth it? Also, hedging substitutes, but does not eliminate, risk. Are you willing to accept the new risks? One hedging instrument for interest rate moves are inverse Treasuries ETFs. These are complex securities that warrant a fuller discussion than we can provide here.
At Price Wealth Management, we build sensible portfolios, informed by history, for you based on your unique needs. The future is ours, but not ours to know in advance.
The information set forth herein is for informational purposes only and should not be used as the sole basis for an investment decision. This material contained herein should not be considered a recommendation to buy or sell securities in the United States or in any other jurisdiction. Investors should carefully consider the investment objectives, risks, charges, expenses of a fund or investment strategy before investing. Investment in a portfolio, investment manager, or security should not be based on past performance alone. Investing involves risk and you may incur a profit or a loss. Diversification does not ensure a profit or guarantee against a loss.