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Investing and the Public Information Age

The performance of bonds and other interest rate-sensitive securities in the second quarter surprised and scared many investors. One big reason was how global markets processed one particular piece of public information. In this blog post from TraderPlanet.com, David Blain explains why you should not put too much stock in what you read or hear from the financial media.

Selling Off Bonds a Bad Idea

Bonds have had a rough time of it lately and many investors are getting jumpy. This jumpiness has started what the pundits call the “Great Rotation” out of the bond market. But if you do sell off the bond allocation in your portfolio, where do you go? Cash? Not with interest rates so low. Hedgefunds? We don’t think so.

The truth is, a broadly diversified portfolio has offered the same returns during periods of rising rates (falling bond prices) as it did during periods of falling rates (rising bond prices). For example, returns for the period 1947-1982, when rates were rising, are almost identical to the period 1982-2012, when rates fell.

The fact is that bonds will not return 6%-8% for the foreseeable future. Returns are most likely going to be in the 3%-4% range. But bonds still play a vital role in a portfolio as a hedge against volatility. Perhaps the size of the allocation will change, but we are not abandoning bonds altogether.

Don’t Abandon Bonds Completely

Bonds experienced significant declines during the second quarter and many investors panicked as a result. We believe this overreaction to a short-term event will not be rewarded over the long-term. In fact, markets in general made up all of the second quarter losses and more.

Now if bonds were to experience a sudden, dramatic spike in interest rates (a steep drop in bond prices) it could take years to recover (after all, a one percent increase in interest rates reflects five percent decline in values). But bonds have not exhibited that kind of large sell off historically and we don’t see that kind of major event in the foreseeable future.

The truth is, since March of 2009, we have been in the fourth longest bull market in history without at least one 20 percent correction. Stocks have been up 20% year-to-date, 27% over the last year, and 175% since March 2009. Bonds are down 2% year-to-date and 1.5% over the last year. But they are up 25% since March of 2009.

Investors who hesitated to enter the market at the low points of 2008 and 2009, have missed all of the action and are now likely priced out of getting back in. We adjusted our allocations and stayed invested during this period so our portfolios have done well. We can’t predict the future so we will remain diversified making tactical changes as needed.

Public Info Already Priced Into Bonds

Bond performance in the second quarter surprised and scared many investors. This was due in part to statements by Ben Bernanke about the possible scale-back of the Fed’s bond buying (quantitative easing) program. After his remarks, the market quickly priced-in a rise in interest rates which caused bonds and other interest rate-sensitive issues to drop dramatically.

But this drop was actually a demonstration of the market’s ability to quickly take information, form expectations and react in an efficient manner. Essentially, the market re-priced bonds (and the other asset classes mentioned above) to reflect an expected rise in long-term interest rates. It was an efficient event because the number of sellers equaled the number of buyer (as is always the case).

Global markets tend to be very efficient when it comes to pricing in investor expectations about future events. It’s not that professional investors are good at predicting the future—no one really knows what might happen tomorrow—but they do process information pretty efficiently. And they are processing the same information that other individual investors have access to (we’re not talking about insider trading here, that’s criminal activity).

For example, when Ben Bernanke made his statement about the possible scale-back on the Fed’s bond buying (quantitative easing) program, the market quickly priced-in a rise in interest rates. In the days that followed, the market continued to price expectations on rising rates and eventually that affected almost all major asset classes (U.S. large-cap being an exception). Right after the end of the quarter, Mr. Bernanke seemed to walk-back his comments and the market recovered its losses and more.

The volatility of markets during the quarter scarred many investors who simply “moved to cash” instead of weathering the storm. If they had deployed and stuck to a long-term, globally diversified allocation strategy, they would have been fine.

Changes to the North Carolina Tax Code

The North Carolina Legislature passed and Governor McCrory signed new tax laws that will go into effect beginning next year. While we don’t believe the reform went far enough, it is at least a start. Some highlights from the new policy include the following:  Personal and corporate tax rates will be going down next year, the child tax credit and mortgage deduction remain in force, and Social Security will continue to not be taxed. As we said, it’s a start, but the new North Carolina tax code doesn’t go far enough.

Our philosophy on portfolio management is similar to that of an experienced sailor. Once you trim the sails correctly (investment plan), a light hand on the tiller (tactical rebalancing) is all you need to reach your destination (long-term goals). The second quarter of this year proved our philosophy to be true.

When bonds fell off the cliff (taking other interest rate-sensitive issues with them) during the quarter, some of our clients raised concerns about their portfolios. We pointed out that the downward move was well within acceptable parameters and only a short-term event that didn’t require drastic action. Within the first two weeks of July, all of those losses and more had been regained.

Creating An All-Weather Portfolio

Last quarter’s volatility is solid evidence that a properly diversified portfolio with true global allocation (an all-weather portfolio) offers the best long-term chance for financial success. While concern about the tumble that bonds and other interest rate-sensitive assets took was understandable, the drop was well within acceptable parameters and didn’t warrant drastic action (like selling out!).

Within the first two weeks of July, most if not all of the losses had been recouped. The last quarter is also proof that investors get paid to take risks and earn returns over the long run. In fact, the downturn in bonds, REITs, utilities, etc., actually improved their return profiles by increasing potential yield. It also proved our belief that trying to time the market and chase yield is a fool’s errand.

A smart man once said that predictions are hard, especially about the future, which is why we don’t make them. We believe that the global community will—despite some setbacks along the way—continue to demand and produce goods and services. We also believe that, in general, global markets are efficient. The combination of these two factors will provide opportunities to earn returns on a globally allocated portfolio.

Bonds Require Patience Not Fear

In 2008, many investors asked themselves if they would ever buy stocks again. Now, many investors are asking themselves the same question about bonds. That’s because during the second quarter of 2013, bond yields jumped more than many of them had ever seen (the most for 10-year Treasuries in such a short period since 1994).

For us, this sudden spike in yields (and the accompanying loss in bond prices) demonstrated not-so-subtly the inherent risk in investing. However, unlike with equities, there is very little risk that bonds will go to zero (high-yield, or junk, bonds are an exception). Bonds can, however, experience sharp set-backs and thus periods of negative returns.

High-yield (junk) bonds have a much higher risk profile than their investment grade cousins. Also, they tend to act more like equities than fixed-income instruments. Additionally, junk bonds have a higher default rate—around 3 percent during normal times and 12 percent during tough economic times—than other bonds. Finally, despite some similarities in trading behavior (close correlation) junk bonds are not a substitute for equities.

When it comes to income, preferred stocks, while perfectly fine for a portfolio allocation, should never be considered a substitute for bonds. These securities share characteristics of both stocks and bonds (including call provisions), but are more closely correlated with stocks. For a better risk/reward profile, you should consider dividend paying common shares instead.

REITs are excellent for the growth portion of a portfolio, but they reside on the equity side of the “balance sheet.” The same holds for Master Limited Partnerships (MLPs), but they reside in the commodity portion of a portfolio. Neither, despite their income potential, should be considered a substitute for bonds.

The bottom line is, bonds require patience not fear. That’s why we construct diversified portfolios that are allocated for total return (we do not chase yield). After all, while income (interest) is good, it can’t be your only strategy. Not only is it too risky, it can be very tax-inefficient.

Bonds Require Patience Not Fear

In 2008, many investors asked themselves if they would ever buy stocks again. Now, many investors are asking themselves the same question about bonds. That’s because during the second quarter of 2013, bond yields jumped more than many of them had ever seen (the most for 10-year Treasuries in such a short period since 1994).

For us, this sudden spike in yields (and the accompanying loss in bond prices) demonstrated not-so-subtly the inherent risk in investing. However, unlike with equities, there is very little risk that bonds will go to zero (high-yield, or junk, bonds are an exception). Bonds can, however, experience sharp set-backs and thus periods of negative returns.

That’s why we construct portfolios that are allocated for total return (we do not chase yield). After all, while income (interest) is good, it can’t be your only strategy. Not only is it too risky, it can be very tax-inefficient.

Don’t Substitute These for Bonds

When it comes to income, preferred stocks, while perfectly fine for a portfolio allocation, should never be considered a substitute for bonds. These securities share characteristics of both stocks and bonds (including call provisions), but are more closely correlated with stocks. For a better risk/reward profile, you should consider dividend paying common shares instead.

REITs are excellent for the growth portion of a portfolio, but they reside on the equity side of the “balance sheet.” The same holds for Master Limited Partnerships (MLPs), but they reside in the commodity portion of a portfolio. Neither, despite their income potential, should be considered a substitute for bonds.

2nd Quarter 2013 Quarterly Market Review

2nd Quarter 2013 Quarterly Market Review

This report features a commentary on bonds and portfolio construction, a market summary, a timeline of events for the last quarter and a look at world asset classes.

Adapting an Investment Process

We highly recommend that you stick to an investment process when planning for retirement. The first decision you need to make in this process is whether or not you want to do it yourself. Obviously, we recommend you delegate this to a fee-only advisor (preferably a NAPFA member) who has a fiduciary obligation to their clients. It’s also advisable to choose an investment professional with the right credentials (CFA, CFP, etc.).

If you decide to handle your investment portfolio yourself, don’t get caught up in what you see, read or hear from the financial media machine. While knowledgeable, the primary focus of television, magazines and newspapers (including the Wall Street Journal), is to sell commercial time, ad space and increase their circulation. This tends to tilt them toward more sensationalized stories and also, by the time you see something in the financial media, chances are it’s already been priced into the market.

Your best bet is to take a hard look at your risk tolerance and create a portfolio with a broad allocation among asset classes including growth (equities), stability/income (bonds) and accepted losses (cash). If you do this and stick with it for the long-term making tactical changes along the way, you will likely enjoy a comfortable retirement.

The Value of Bonds Goes Beyond Their Coupon

One of the most frequently asked questions we get is should I continue to keep bonds in my portfolio? After all, bond yields are at historic lows and fear of inflation has many investors on edge. When we construct a portfolio for our clients, we use a variety of asset classes including bonds, equities, real estate and commodities.

Bonds, while not yielding what they used to, are still valuable as a hedge against volatility. The bottom line is that the value of bonds hasn’t gone down, it’s simply changed. And, if we have another financial crisis (and it’s likely that we will), bonds are likely to be very helpful in limiting the downside for our portfolios.

Speaking of a financial crisis, the great calamity that many economists and pundits have been predicting—runaway inflation—has not happened. This is due in part to the self-fulfilling nature of widely disseminated predictions in the financial media. Simply put, when faced with an overabundance of warnings such as rising inflation, people (including the Fed) take actions to prepare for it. When they do, it often prevents the predicted event from happening.

We’ve cautioned in the past against watching too much CNBC.

Bonds Still Valid/Big Business of College

One of the most frequently asked questions we get is Should I continue to keep bonds in my portfolio? After all, bond yields are at historic lows and fear of inflation has many investors on edge. But bonds, while not yielding what they used to, are still valuable as a buffer against volatility. The bottom line is that the value of bonds hasn’t gone down, it’s simply changed.

Many in the media are forecasting the eminent demise of the bond market due to (eventually) rising interest rates and inflation. But rising interest rates and inflation don’t necessarily mean that bonds are suddenly going to tank. Historically, bonds have offered decent returns during such periods. This is due in part to the fact that investors tend to flock to bonds during periods of uncertainty.

The bottom line is that we build diversified portfolios for our clients based on needs, goals (rate of return requirements) and risk tolerance. And, right now, bonds still play a key role in this process primarily as a buffer against volatility.

With spring time come high school graduations and decisions about going to college. One thing that people need to realize is that college has become a big business just like pharma and oil. That’s not to say that college isn’t worthwhile, it is. But, you need to evaluate what you want to study and why, then choose a college that provides a good education at a good value.

This is more important than ever these days as the job market continues to narrow in terms of high-paying jobs. Sadly, the days of simply earning a liberal arts degree and getting a good job are over. Today, degrees in computer science, engineering and medical-related fields are where the money is.

Bonds Still Valid In a Diversified Portfolio

We build diversified portfolios for our clients based on needs, goals (rate of return requirements) and risk tolerance. Right now, bonds still play a key role in portfolio construction primarily as a buffer against volatility. This is especially true for high-quality bonds such as corporate and short-term Treasuries. Historically, this philosophy has proven to be successful.

Bonds as a money-making investment have lost some of their luster. With rates so low, yields on most bonds are not very attractive (unless you are willing and able to assume an undue amount of risk). That said bonds have consistently had positive returns through the years. It really boils down to where interest rates are.

But rising interest rates—a common current prediction among pundits—don’t necessarily mean that bonds are suddenly going to tank. Historically, bonds have offered decent returns despite periods of rising interest rates. This also holds true for periods of high inflation even though inflation typically eats away at investment returns.

Clearly, the demise of the bond market due to rising interest rates or high inflation is greatly exaggerated. One of the main reasons for the resilience of bonds is that investors tend to flock to them during periods of uncertainty.

Real Estate As An Alternative To Bonds

Income-producing real estate can be an attractive alternative to bonds, especially with yields so low. In the article from the Wall Street Journal, David Blain talks about his approach to investing directly in real estate.