To get that lower-volatility return stream, you need to think differently
Interest rates have been in a progressive downward spiral for a very long time. Rates on the benchmark 10-year U.S. Treasury Bond peaked in the early 1980s.
For a 25-year old just starting to save money in an IRA account, this is, to coin a phrase from the Monty Python vernacular, “merely a flesh wound” to their retirement plan. Same thing for a 40-year old business owner just starting to fund their SEP or 401(k) plan.
But for someone who could potentially use that money within 10 years, much less 5, the impact of a recession, and the bear market in stocks that typically accompanies it? That is devastating!
For retirees, getting to higher rates won’t be much better
And, while bond investing has historically been considered the “safe, alter-ego” to the stock market, that history repeating is not likely. After all, today’s retirees may be the only ones old enough to remember when U.S. mortgage, bond and savings rates were over 15% (circa 1980). That was not the bargain it appears at first sight.
Those high rates were accompanied by sky-high increases in the cost of living (inflation). Yet since the early 1980s, interest rates have generally been on the decline. As a result, the long-term returns available from bonds has created a major headwind for those who have accumulated wealth. Now, they need to prioritize keeping it.
For bonds, the glory days are gone
This is the case because when bond rates are low, it means that the “total return” you get from a combination of the bond’s income payments plus its price appreciation are quite limited. The glory days for bonds are when rates are historically high and heading lower. That was the story of the past 3 decades. However, it is not at all where things stand today.
This is simply because bond prices appreciate when rates fall, and vice-versa. It follows that during all the years when rates were falling, bond investors were getting an extra kick up in value on top of an already nice level of interest. This produced total returns for bonds that are nearly impossible to replicate during the next decade.
That means that retiring or retired investors can’t hide out in bonds as part of their asset allocation strategy within their financial plan. Instead, they must confront head-on the likelihood of lower returns than they are used to. In other words, they must evolve their investment approach. This is where hedged investing can be a most valuable addition to your investment arsenal.
Rates may stay low, but that will produce insufficient returns. Rates may rise and that will shock investors, as they see bonds lose significant value for the first time in their investing lives and just when they need bonds to be the “safety valve” they assume they are. Or, rates may continue to fall toward zero and perhaps even negative, as we have seen in other parts of the world. But that would imply some pretty dire financial conditions and take away whatever yield potential remains.
Hedging and football: a simple analogy
To effectively replace bonds in your portfolio without courting a lot of risk, or resorting to outright “market-timing,” there are several moving parts that must be organized and understood. These keep the portfolio doing what it is intended to do.
It starts with dividing your portfolio approach into 2 teams, sort of like in football. There is an offensive team, and a defensive team. However, unlike in football, these teams are on the field at the same time. Translated back to investing, there is a “long” side to the portfolio and a “short” side to the portfolio.
What goes into those long and short parts of the portfolio is the subject of a much longer article or discussion. Suffice it to say that with bonds providing little help beyond modest additional upside from here, long and short sides of the portfolio can work in tandem to help you target your desired level of volatility.
Crash protection
And, when markets have short-term or intermediate-term hiccups, we don’t have to scramble around to make sure we are protected against catastrophe. That protection is already accounted for within the strategy through hedging. We only need to adjust it from time to time. After all, the defense part of your portfolio will include some investments that by their nature should profit when the stock or bond markets sink.
The key difference between one client’s hedged portfolio and another is not the stock/bond mix. It is the degree to which the portfolio is hedged. The most aggressive accounts might not hedge unless a market storm seems imminent. The most conservative accounts may never have more than a modest net exposure to stocks (20%, 30% 40%).
Your choice
Hedged investing is whatever you want it to be. It is very flexible. That means you can take the principles and structure, and personalize it as you wish. I aim to bring more detail to you on this topic in the months ahead.
The bottom line: bonds are at best a mediocre asset class to rely on. Investors who are more interested in making their money last then growing their capital aggressively need to pivot from the traditional to an alternative route.