| 05 April 2004
In a previous commentary I promised to look at some specific strategies for investing in this uncertain market.
Fear of the stock market is still keeping some people on the sidelines in money market or other stable value investments. Those who were not in the market in the first place are now hesitant to initiate an investment plan. These feelings are understandable, but too much caution can doom a financial plan to failure.
Earning less than 1% on savings and money market accounts is not too appealing, but at least you’re not losing money, right? Well, actually you would be. After paying taxes, and allowing for inflationary cost increases, these accounts are losing ground every day that goes by. The purchasing power of this money will be continually eroded, causing loss of principal over the long run.
Jack Bogle, founder of the Vanguard funds – who is known to be fairly conservative – has said that rising life expectancies and longer retirements have changed the way you should look at stable accounts. Absolute principal protection should not be your prime directive. Short-term needs for cash must of course remain in low-yield accounts for safety, but long-term investment dollars need to be directed to assets that can increase over time above the rate of inflation.
Bonds are an alternative to cash accounts because they produce a higher return over the long run yet are fairly stable. Recent media attention, though, has generated almost as much fear of the bond market as the stock market. I think this is a bit overdone, although the key point is undeniable. Bonds, especially those with longer maturities, can drop in value very quickly when interest rates rise. And the consensus of experts is that interest rates will have to rise.
With bonds at 40 year lows in terms of yields, this means that bond values (the price of the bonds) are at 40 year highs – since bond prices move in the opposite direction of bond yields. This does not bode well for total returns from bonds for the next few years and makes it a precarious time to invest in bonds or perform a radical reallocation from cash or stocks into bonds.
In the last couple of months alone, the Vanguard Total Bond Market Index Fund, which mirrors the entire bond market, lost about 3.5%. This is not devastating, but certainly not what investors had in mind when they included bonds in their portfolios. Nevertheless, bonds are an essential part of a long-term investment plan and should comprise 20% to 40% of most people’s portfolios.
The key is to diversify the types of bonds or bond funds just as you would hopefully diversify among different types of stocks. Bond funds can be purchased with different average maturities for the securities owned by the funds. Most advisors are staying clear of long-term bonds because they are highly sensitive to changes in interest rates. Short-term and even ultra short-term bond funds are now available, which can boost yield without taking on too much extra principal risk.
High quality bonds should comprise the bulk of the income side of a portfolio, using a combination of U.S. government, government-backed and corporate issues. Adding some high yield (lower quality) bonds, though, can increase yield and give greater diversification. High yield bond funds, for instance, recently lost less than half as much as the broader market because they are more influenced by credit issues and the strength of the economy than by interest rate changes.
Treasury Inflation Protected Securities (TIPS) are also a good way to diversify your income portfolio and still be conservative. Both Vanguard and Fidelity offer no-load funds that invest in these bonds issued by the U.S. government which provide a real return (above inflation) and adjust for inflation. This provides a nice hedge against inflation down the road which is quite harmful for fixed income securities. TIPS are generally best held in tax-sheltered accounts because they generate “phantom” income if held in taxable accounts.
The need to diversify the equity (stock) side of the portfolio is a constant theme rendered by financial planners. This is particularly important in uncertain markets. Some investment styles will perform much better than others at any particular time. The returns from small growth stocks, for example, have about doubled those of large value stocks for the first seven months of this year, gaining about 24%. Investors should keep an appropriate mix of small, medium and large companies in their stock portfolios, and also diversify by industry, geography and style.
Another way to diversify is to add a low-cost real estate fund. Again, both Vanguard and Fidelity offer funds that invest in Real Estate Investment Trusts (REITS) to easily gain exposure in this asset class. Through a no-load real estate fund an investor can get benefits that are difficult to obtain with direct ownership of real estate, such as broad-based exposure to different sectors of the real estate market, liquidity, professional management and convenience.
The best way to navigate through uncertain markets is too employ a mix of cash, bonds, stocks and real estate. The exact composition would depend on your particular goals, financial situation, and comfort level with risk. There is no need to seek out hedge funds, complicated insurance policies or other questionable products and strategies being touted by some advisors these days. These invariably have high costs and poor liquidity, or are difficult to implement and manage.
To learn more about the investment strategy used by VisionQuest Financial Planning LLC, refer to the Investment Policy document in the Client Forms section of this web site. And remember, to have the best chance to achieve your financial and lifestyle goals, stick with proven strategies to build and maintain a portfolio that is right for you.
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