I’ve never met a successful entrepreneur whose growth strategy was rooted in staring into the rear-view mirror. It sounds patently absurd, right? What worked (or didn’t work) last year is kind of irrelevant. Your bandwidth is spent on positioning your firm to take advantage of where you expect the market demand to be going forward, not where it was last year or quarter.
I hope you are just as future-focused with your investment portfolio. But the data tell me your investing strategy may be suffering from rear-viewitis.
Bonds vs. Stocks
Through the first 11 months of this year investors poured a net $346 billion into bond mutual funds and exchange traded funds according to Morningstar. The tally for stock funds and ETFs: a net inflow of $11 billion.
That’s a continuation of money flow trends that started during the financial crisis. If you’re a part of the post-crisis bond rush, now is an important time to give your portfolio the equivalent of a hard-nosed business review. An outsize allocation to bonds over stocks at this juncture isn’t much different than doubling down your business on a shop-worn strategy that has run out of juice.
A 10-year Treasury note has a nominal yield of 1.9% and a AA-rated corporate bond ekes out an average yield of 2%. Thing is, core inflation is running at about 1.9%. So your real return is hovering around zero. Before the financial crisis Treasury bonds delivered a 2% real yield, and high-grade corporates around 3%. There’s risk in any investment that does not provide a real return.
And the road ahead for bonds is looking anything but investor-friendly. Unless you were investing back in the 1970s and early 1980s you have never seen the dark side of bonds: rising interest rates. When bond yields rise, prices fall. When bond yields fall, prices rise. The latter is what we’ve enjoyed for more than 30 years; in January 1982 the 10-year Treasury had a yield of 14.6%. As that yield fell over the ensuing decades--to its current rock bottom 1.9%--bond prices rallied, creating the solid total returns the rearview mirror crowd remains focused on.
Thing is, eventually today’s repressed bond rates--a function of aggressive post-crisis monetary policy--will rise. When that happens the value of bonds will fall.
If you’re investing in bonds via a fund or ETF check out its average duration. That’s a measure of how the portfolio would react to a change in interest rates. The duration is how much the price of the underlying bonds will fall/rise if interest rates were to fall/rise one percentage point. So for example, if a fund’s duration is five years that means the price of its underlying bonds would decline by 5% if interest rates were to rise just one percentage point. The $18 billion Vanguard Total Bond Market ETF (ticker symbol: BND) has a current duration of nearly five years. Its most recent annualized yield is 1.61%. Even a yield increase to 2.6% wouldn’t be enough to offset a 5% price decline.
That’s not to suggest bonds are a bad investment. I want to be clear: Every diversified portfolio should own bonds. They are the life vest in stormy seas. The worst one-year return for intermediate-term Treasury bonds since 1950 was a -1.3% trim in 1958. The worst year for stocks since 1950, as if this needs to be pointed out, was the -37% decline in 2008. Bonds are important ballast for your portfolio. But if you’ve spent the past few years expanding the bond piece of your allocation pie you’re putting your long-term goals at risk.
Yes, stocks definitely are more volatile. But for an investment goal that is 10, 20, 30 or more years off, stocks are what have historically provided the strongest inflation-beating real returns. And because of where rates are today there is little chance of strong total returns for bonds going forward. Eyes on the road ahead works for your business. Make sure it’s what drives your portfolio as well.