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For decades the stock and bond market have both performed exceptionally well…often at the same time. This challenges basic allocation strategy and questions our perception of correlation between stocks and bonds. The adage is that when stocks do well, bonds will suffer and when stocks suffer, bonds will do well. That is a basic axiom that investors rely upon when creating a diversified portfolio.
But what we have seen over the decades, thanks to a 40-year bull market in bonds, is that these two are more highly correlated primarily due to how they respond to interest rates. When interest rates go down, bond prices go up. When interest rates go down, the cost of capital goes down. This supports investment, higher earnings and equity valuations.
Over the past decades stocks have done very well, and bonds have done pretty well. So what happens when things change course? There is no question we are facing inflation right now. The big question is how transitory/permanent the inflation will be. Interest rates have started ticking higher. If the Fed raises rates or the expectation is that rates will go higher, that will cause bonds to lose value and likely will result in a selloff as equity valuations compress.
We could face a situation where both stocks and bonds perform poorly for a period of time. And that period may be longer than what investors have the patience for. As investors, we have been spoiled with returns over the past decades. Many of us may not know (or forgot) what patience, discipline and perseverance in investing is really like.
What Is An Investor to Do?
If we believe stocks and bonds may generate negative returns for a period of time, what is an investor to do? Where can an investor hide? Certainly, there will be sectors of the market that perform better than others, and other assets may do well. These will become blatantly obvious in hindsight, but for the present time the best any of us can do is give our best, educated guess. We can look at history to get an idea of assets that do well in inflationary environments etc…
But for many investors, the temptation will be to go to cash. While most investors would admit that going to cash is not a wise investment move, the temptation is so strong that many may choose it anyway. Why invest in assets that we know are going to go down? The illusion of certainty changes our belief or probability into certainty, and we are tempted to act on it. If we are in cash, we rationalize that it will just be for a short time and then we will enter in the market when things are better. So many assumptions made in that one sentence…
Cash is King?
When markets go down, “cash is king” will be all over the news. While cash is essential to our everyday living, how exactly is it king when it comes to investing? Let us not confuse cash for living and cash for investing. Once an investor goes to cash, they leave the realm of investing and enter the realm of speculating. Even if we knew the markets would sell off, how long will it last, how will we know whether the recent uptick is a rally within a bear market or a launchpad from the bottom? Going to cash provides instant relief but creates more uncertainty and anxiety in the long run.
Take an Investment Sabbatical
Conviction in what we own, the allocation we have as well as dividends we receive can help investors stay the course. The power of compounding is one of the greatest universal forces we know. When investors go to cash, they stop that power. So even if the market goes down, we can be confident in what we own and that we are being paid to wait. But that still may not be enough for the anxious investor. In that case, perhaps a sabbatical from investing is needed.
During the sabbatical, the investor stops looking and gets paid from the dividends and interest from the portfolio. That can either be paid directly to the investor or reinvested at lower prices (assuming market is going down). The sabbatical can help them re-focus on those things that really matter in life and those things within their control. This will greatly improve their quality of decisions and life…and ultimately the value of their investment portfolio.
Related: The Illusion of Rationality