As with most things in life, it’s uncommon to find a free lunch in investing. Generally speaking, investment returns tend to be commensurate with the level of risk incurred.
However, it seems some investors are questioning that rule and reacting to the current low interest rate environment by reducing their allocation to high-quality fixed income securities and raising their allocation to riskier asset classes (like equities or lower-quality fixed income securities). We caution against efforts that purport to offer an increase in expected portfolio returns without a commensurate increase in risk. We also caution against letting the tail wag the dog: when determining a portfolio’s asset allocation, ability and willingness to bear risk is paramount, not expected returns.
With long-term interest rates at historical lows, many investors have questioned the role of bonds as part of a long-term asset allocation. Their reticence is understandable: simply put, high-quality fixed income securities do not generate anywhere near as much income as they did five or 10 years ago. As of August 24, 2020, the 10-year U.S. Treasury note yielded just 0.65%, which is significantly down from the average yield of 2.14% in 2015 and 3.22% in 2010.
As a result, some have turned their attention to equities, which appear like an apt alternative for income generation. Today, more than 75% of companies in the S&P 500 have a dividend yield that is higher than the yield on 10-year Treasuries. Investors willing to look beyond equities can also find higher yields through alternative asset classes like real estate and Master Limited Partnerships.
That said, we would caution against this somewhat simplistic comparison. For one, treasury coupon payments are predictable (the closest thing you’ll find to “risk-free” in investing), which is not the case for dividend payments, particularly in the short-term (as an example, dividends paid by S&P 500 companies in 2009 collectively declined by more than 20%). In addition, price declines can quickly negate the benefits of higher income provided through the ownership of common stocks.
Beyond equities, many alternative income strategies (products) are marketed as “low-risk” while offering 3 to 4 percentage points of higher returns than government bonds. Returning to the idea of “no free lunch,” it’s likely that the level of risk, the level of returns to be generated over time, or both, are being misrepresented. In reality, these products carry significantly higher risk compared to bonds — and tend to come with much higher costs in terms of commissions or expense ratios as well. Simply put, higher yields generally come with higher risk and the potential for losses. If it looks too good to be true, it probably is.
In the equity portion of a client’s portfolio, we believe investing in high-quality businesses with attractive long-term growth prospects is the best way to compound wealth over time. That said, we maintain that bonds play an important role in a balanced investment portfolio. The primary purpose of bonds is to preserve capital in your portfolio while reducing the impact of inflation. The income that bonds generate, coupled with their relatively low-price volatility, can help mitigate overall portfolio risk, especially when the market is in flux. Our goal is to set reasonable expectations and to make sure that our clients’ portfolios are strategically diversified and based on their risk tolerance.
Although a 60/40 split between stocks and bonds is somewhat of an industry standard, we tailor each client’s investment portfolio to match his or her ability and willingness to bear risk. In today’s market, when many are tempted to reach for extra yield or returns through esoteric or risky products, we think it’s timely to caution our clients against such activity. In too many instances, we’ve seen these efforts prove counterproductive.
In February and March, when the S&P 500 fell by more than 30% from peak to trough, high-quality bonds were one of the few asset classes that remained unscathed. Of course, correlations can shift as market dynamics change, but bonds have historically done a good job providing a counterbalance to declines in stock prices.
Make no mistake: bonds are unlikely to provide the 4-5% returns that were typical over the past two decades. However, now is not the time for investors to increase the risk in their portfolio to replace that level of income. The more appropriate course of action in a low-interest rate environment is to reset one’s expectations to reflect today’s reality.
Maintaining a balance of equity and bonds has proven to be a successful way to help investors tolerate volatility while continuing to compound wealth over time. Instead of focusing on “quick-fix” solutions to generate income, focus on sustaining a disciplined strategy to generate long-term returns.
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