12 years ago
What does “safe” mean? When driving car or playing baseball, the answer is generally clear. When investing, the answer is less obvious. To get where you want to go financially, it is critical to properly frame the problem, by asking the right questions: safe “from what risk?” and “when?” Safe from volatility risk? Or interest rate risk? If so, at the expense of inflation risk (i.e. purchasing power)? Longevity risk (i.e. the risk of running out of money before you run out of time)? Goal risk?
During the recent global financial crisis and “Great Recession,” many investors felt “unsafe” due to the drops and volatility of the stock market. Despite the global stock market’s rise of about 100% since the bottom (MSCI All-Country World Index 3/9/09-9/28/12), the average investor mentality remains more volatility-averse than normal. This phenomenon is also unusually true for young investors whose experience is limited to the last 10 years, which includes the 2nd and 3rd worst markets in history.
With these concerns, investor fondness grew for the bond asset classes that provided some protection during those difficult markets. After all, if bonds were safe then, more is better, right? Not exactly…
First, with government bond interest rates driven to historic lows by the Federal Reserve Bank’s economic stimulus strategies, “interest rate risk” is higher than it has been in decades. While interest rates are not expected to rise in the immediate future, when (not if) bond interest rates eventually rise, bond prices will fall, and can lead to materially negative returns in the short-run, especially if rates rise quickly and in large steps. As discussed in our recent Quarterly Context webinars and videos, a 1% rise in rates could cause broad bond market prices to drop 7%, and could cause 30-year U.S. government bonds to drop 19% in value. Diversification in bonds can help address this future problem, but can’t eliminate it.
Second, while the bond market may rarely have negative returns, the long-term expected return of bonds is not sufficient, without stocks and proper savings levels, to accomplish most people’s financial goals.
Hence, the need to properly frame the problem. If staying “safe” from short-term stock or bond market volatility is your only goal, then there are solutions to solve that problem. However, those solutions may be in direct conflict with the more important problem of avoiding long-term financial failure, which requires the acceptance of short-term volatility in any given asset class as the price for long-term success.
The human brain is an amazing learning mechanism, and naturally attempts to avoid repeating past negative experiences, which can be fundamental for daily survival. However, these short-term and historical biases can lead people to improperly frame or entirely avoid addressing complex long-term problems that have not yet occurred. Keep your eyes on the prize, and your finger off the panic button.
