How much will your bond allocation loose if the interest rates go up 1 percent? Good article to explain the impact of raising interest rates on your portfolio.
Asset Allocation is Alive and Well by Dale Roberts
Low interest rates are approaching historic lows. Those rates have killed the potential for bonds and especially bond funds to deliver any kind of performance over the next several years, so say the nay-sayers. Bonds have had a great time the past three decades. How could it continue? Here`s a long-term chart thanks to ritholtz.com:
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And those who practice asset allocation and have held balanced portfolios of 50-50, 60-40 equities to bond allocation have mostly outperformed their all-stock friends and colleagues. That is a rarity for sure, that balanced portfolios outperform the high-test, high-equity growth models. But that’s been the reality over the last five, 10 and 15 years.
As I stated in my article entitled “No One Makes Money from the Stock Markets,” it’s the recent investment climate or cycle that matters to investors. Not 40-, 50-, 60- or 100-year averaged trends. Who invests for 40 years? Warren Buffett and, and, and …. well think of another name or two and get back to us. I’m not suggesting that all investors should hold a balanced portfolio (you should hold the portfolio that matches your time frame, objectives and risk tolerance), but in the recent environment it has been a bond fund holders’ dream come true.
Interest rates have been falling for a few decades giving bond holders that added shot in the arm. But interest rates are running out of room to fall further. They have painted themselves into a corner. Many experts offer that interest rates have to rise. They’ve been reminding us for three years or more. But we could also stay in an artificial government-manipulated low rate environment for a decade or more. Just look at Japan. Interest rates have been falling and have remained low for a couple of decades. And during this time period, bonds have continued to outperform Japanese equities, and even the classic 60-40 balanced portfolio.
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But certainly, there’s also the chance that interest rates will rise in the mid or near term. Bond holders likely can’t party like it’s 1999. And no one rings a bell to let you know that the interest-rate-increasing event is about to happen. And there’s certainly investment ‘risk’. As you may know, if interest rates rise bond unit prices will go down. The basic formula goes like this; bond unit prices will go down at (the rate increase percentage x the bond duration). So if you hold a broad-based bond fund with an average duration of eight years, and interest rates increase 1%, your bond fund’s price will take an 8% haircut. Granted you will still collect your bond income from the stream of coupon payments the fund is receiving. Even if you collect your income – let’s say 4% – you’re still down 4% on the year.
So let’s look to history to examine the performance of asset classes during a time frame when we experienced an extended period of low but rising interest rates. And for that info, we’ll go back to the 1950s and 1960s. Thanks to a Vanguard article and chart published in 2012, we can have a look back.
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As we can see (and may already know from our economic history) the equity markets experienced one of the greatest secular bull runs from 1950 to 1965. Equity investors would have seen a 600% return in price terms alone, and likely 1000% or more returns when factoring in any dividend reinvestment. But we can also see that those who held the classic balanced portfolio model also experienced a ‘six bagger.’ That is 600% total returns from that 1950 start date. They were still invited to the party.
And most importantly, past performance does not guarantee (or predict) future returns. Anything could happen. And that’s why investors with moderate or average risk tolerance should stay the course, and maintain that 60-40 balanced portfolio. Even if 1950-65 behavior repeats itself, you are going to go on a very, very nice run with much lower volatility than an all-equity or more growth oriented asset mix.
We should also examine why you opted for the balanced approach in the first place – your risk tolerance. Has your tolerance or appetite for risk (I prefer the word volatility) changed? Not likely, you’re one year older today than you were in February of 2012. And one year shorter on your investment horizon. Net net, your risk tolerance has not likely changed, so don’t abandon the plan.
In the end it’s all about sticking to the plan. If you go chasing returns with more equity exposure and move outside your level of risk tolerance, we all know what is likely to happen. You’re going to sell when the going gets tough. We should all stick within our level of risk tolerance – always. There is never a good time to go step over that line. That’s when mistakes happen. The only good investment plan is the investment plan that you can stick with.
Look at the most successful investors on earth and they all share many of the same qualities and behaviors. They use their two or three greatest weapons – a long-term horizon, patience and fortitude. And they ignore market noise, even if that noise comes from the bond side of the equation. And well, ya, you gotta have some money to throw in the game as well of course. So let’s add saving to that list. You have to live within your means (heck, let’s even try living below your means) and invest and reinvest on a regular basis. One of the greatest favors you can do for yourself is to pay yourself first, and get your investments on an automatic savings plan. You can set that up automatically to run on auto pilot, or make a schedule of investment amounts and how often you will reinvest (monthly or bi-weekly). It’s a great habit, right up there with exercise and quitting smoking.
In conclusion I would remind readers that of course, no one knows where any asset class is going at any time, short or long term. To make guesses, and alter your investment strategy could be costly. In a recentarticle, I looked the S&P 500 (SPY) and how it reacts when Mr. Market makes new all-time highs. It’s a coin toss. It’s always a coin toss.
If you’re an investor who added bond exposure to temper portfolio volatility and add income, stay the course. It’s likely you’re going to need those shock absorbers moving forward.
That classic balanced portfolio is certainly alive and well. And it is likely to continue to serve you well, if you stay the course and resist the urge to guess.
Additional disclosure: Please note that Dale Roberts aka cranky, the crankywriter, the scaredy cat investor is not a licenced investment advisor, and the above opinions should only be factored in to an investor’s overall opinion forming process. Consult a licenced investment advisor before making any investment decisions. Pretty please.