It’s been approximately a decade since the Great Recession began. By the end of 2008, the U.S. Federal Reserve had lowered the fed funds rate to near zero and embarked on a campaign of “quantitative easing,” delivering a booster shot of lending, borrowing, and spending to revive the economy. Now the Fed is reversing course, restoring monetary policy and targeting historical norms by gradually raising interest rates and tightening policy.
What can investors do if interest rates continue to rise? And what if interest rates level off? Our advice may not be action-packed, but there are a number of solid, evidence-based strategies to guide the way.
Guiding Rule #1: Invest According to a Sensible, Customized Plan
There’s no substitute for having a detailed investment plan, ideally written and signed. A personalized plan is a touchstone for investment decisions, including building and maintaining a suitable balance between stocks and bonds, and determining what to include within the bond portfolio.
Having no plan produces a continuous struggle to predict how, when and if it’s time to react to greater events over which you nor we have any control. No one can guarantee that any plan will deliver the desired outcomes, but simply having a plan greatly improves the odds, sometimes greatly.
Guiding Rule #2:Let the Evidence Be Your Guide
With a solid written personalized plan in place, investors can take advantage of decades of empirical evidence that helps us understand what role each type of investment plays in a portfolio.
Stocks (equity) or stock funds are the most effective tool for those seeking to build more wealth over time. But along with higher expected returns, they also deliver a bumpy ride, with increased uncertainty over whether and when goals can be attained.
Bonds (fixed-income) or bond funds can smooth out that bumpy ride and serve as a safety net against market risks. They can also contribute modestly to a portfolio’s overall expected returns, though that is not their primary role.
Cash and cash equivalents tend to lose buying power over time due to inflation, but it’s great to have enough on hand for near-term spending needs. Adequate cash reserves also help investors keep their stock and bond holdings invested as planned, so they aren’t forced to sell at inopportune times.
By staying focused on these principles, you can evaluate whether your bond holdings are fulfilling their highest purpose within your unique total wealth management plan.
Guiding Rule #3: Bonds Are Safer, but Not Risk-Free
When your financial resolve is being tested, it helps to know that, compared to stocks, bonds have historically exhibited lower volatility and market risks, along with commensurate lower returns. But they do exhibit some volatility, as well as some market risk. Because bonds represent a loan versus an ownership stake, they carry two types of risks that don’t apply to stocks:
- Term risk – Bonds with distant maturities or due dates are riskier, so they tend to return more than bonds that come due quickly.
- Credit risk – Bonds with lower credit ratings (such as “junk” bonds) are also riskier, and tend to return more than bonds with higher credit ratings (such as government bonds).
The decisions investors make about the risks inherent to their bond holdings should be managed according to the particular role bonds play in their portfolio, as we will explore next.
Guiding Rule #4: Focus on What You Can Control
Where does all of this leave a long-term investor? Here are some points to consider when positioning fixed-income assets across various market conditions.
Are your fixed-income holdings the right kind, structured according to your goals?
Just as there are various kinds of stocks, there are various kinds of bonds, with different levels of risk and expected return. Because the main goal for fixed-income is to preserve wealth rather than stretch for significant additional yield, we typically recommend high-quality bonds with appropriate maturities to match each investor’s situation.
The core bond strategy for most investors should be a diversified bond market approach modified to consider the level of equities an investor holds in their portfolio.
For investors with a smaller allocation to equities and larger allocation to bonds, the lower return of bonds puts the portfolio at risk of being outpaced by inflation. As a result, these investors should buy more inflation protected securities to protect against unexpectedly high inflation.
For investors with a higher equity allocation and smaller allocation to bonds, the primary role of bonds is to provide diversification when the equity portion of the portfolio declines. In these portfolios, investors should consider buying long-term, high-quality bonds because they historically have gone up when stocks have gone down.
Finally, are you keeping an eye on your costs? One of the most effective actions you can take across all your investments is to manage expenses. When investing in bond funds, this means keeping a sharp eye on the expense ratios and seeking relatively low-cost solutions. For individual bonds, it’s especially important to be aware of opaque and potentially onerous “markup” and “markdown” costs. While these costs don’t typically show up in your trade reports, they are very real, and can detract significantly from your end returns.
Managing the Unmanageable Markets
Whether interest rates are rising, falling or standing still, it is wise to heed decades of empirical evidence on how to earn long-term returns and manage related risks within a total portfolio approach. That means looking past breaking news and fickle forecasts. (Even if interest rates are rising, we don’t know how the markets will react.) It means detecting and minimizing costs and taxes. It means remaining focused on your personal goals and ensuring that your portfolio is optimized accordingly. For stocks and bonds alike, these are the most reliable principles for navigating uncertain markets and making the most of your one financial life.
We appreciate your continued trust and confidence and we pledge to do everything in our power to continue to earn your business. Please remember that we are just a phone call or email away if you have any questions, comments, or concerns. We’re here to help.
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