The traditional asset allocation model is broken
For those of you who follow the markets, do you ever worry that something isn’t quite right with the economy but can’t really put your finger on what it is? There is a lot of conflicting data out there to keep most investors confused. Maybe you worry that the market may take another big move down like it did in 2000 or 2008? If so, have you ever called your financial advisor and asked what they were going to do to protect your money in case of another market decline? If you have, I bet you were told: “don’t worry, you’re invested in a diversified portfolio of mutual funds. Plus, you’re in for the long haul, so if the market goes down it will be ok.”
The process of investing is so confusing that most individuals just throw up their hands out of fear and frustration and just hand over their money to these “market professionals”, and basically hope for the best. Having money and knowing what to do with it is quite a burden. What if you lose it? The world of finance is so complicated that most people chose to seek out advice. So you call a financial advisor, and here’s how that process goes: you go into your advisor’s office, you fill out some paperwork and you and the advisor basically decide how much risk you want to take based on your risk profile (80/20, 50/50, 60/40)- and based on that ratio, your money is invested in a “diversified portfolio of mutual funds.” Then your money is invested, and they’re done. That’s it. Your money is protected- right?
Unfortunately for lots of investors, many advisors lost 30% to 50% of their client’s money in 2000 and then again in 2008. What were they protecting exactly? Do you want to live through that kind of volatility again? Even worse is that you give your money to your financial advisor to invest, so what do they do with your money? They give it to someone else to invest- the mutual fund manager. Why don’t they just invest your money? Why are you paying them to manage your money if you have to pay someone else to manage your money too?
Unfortunately, for most retail investors, the answer to these questions is that most financial advisors don’t protect your money, they just invest your money. This is because they simply invest your assets in an asset allocation model and claim that your money is protected. This model has traditionally provided a small hedge, but the real problem with this model is that it was never designed to work in the low interest rate environment we are currently in due, in large part, to the Federal Reserve’s QE (Quantitative Easing) bond buying program. Investing a client’s money is an obvious requirement as a money manager, but it’s not just about investing your money, it’s about managing and protecting your money.
At this point I hope it’s pretty clear that I don’t believe that the way most financial advisors invest client’s money is really the optimal method. There are always going to be numerous risks in the market, but to me the risk isn’t that you’re in the market, it’s HOW you’re in the market. The real risk is that you’re invested in the traditional asset allocation model, and as previously stated, this model was never intended to work in a low interest rate environment. So what does that mean? The basic asset allocation model basically works like this: when stocks go up (risk on), bond prices go down and yields go up (risk off). Therefore, there is a natural hedge built into your portfolio, or at least there used to be. The hedge is still there, it’s just to a much smaller degree and the risk and reward of holding bonds isn’t what it used to be. Prices of stocks and bonds have been rising more or less together for more than 30+ years. Stocks can continue to go higher- bonds, while they can certainly go a little higher, their upside is largely capped. But before we get too far down that road, let’s briefly discuss bond prices and their corresponding yields.
When you purchase a bond you’re basically giving a loan to the issuer of the bond, whether it’s a company, a municipality, the U.S. Government, etc. For example, let’s say you loan Uncle Sam $9,300 for a year with the promise to be paid back $10,000. So you purchase this bond (or T-bill) for $9,300, they give you the security, and in 12 months Uncle Sam gives you back $10,000. So let’s see what the equivalent interest rate would be: you lent Uncle Sam $9,300 and you got back $10,000. So $10,000/$9,300= 1.0752, so you get your money back plus 7.52%, or a yield of 7.52%. So when there is more demand for bonds and prices go, the yield will go down. Let’s say something crazy happens, like the Federal Reserve starts buying U.S. Treasuries and drives the prices higher. So now maybe the price of the bond is $9,700? So you loan $9,700 and a year later you get $10,000, $10,000/$9,700 = 1.0309, so you get back 103.09% of your money- or a yield of 3.09%. So you can see how higher bond prices means lower yields. The main point to understand about a bond is that as the price of a bond goes up, its corresponding yield goes down. So what? What does that have to do with you and your portfolio? What does that mean in the real world? What that means to your portfolio is, because the price of the bond is inversely correlated to it’s yield, the price of the bonds in your portfolio have limited upside potential with much more room to the downside.
Let’s use a housing analogy to illustrate how over-priced most bonds are right now. Let’s say we’re back in 1981 and you are looking for a way to invest some money and are looking for an attractive yield. You look around at all your potential choices and decide to invest in real estate. You eventually find a nice house to buy as a rental and paid $100,000 for it and found a renter that would pay you $1,000 per month. So you would make $12,000 per year on your $100,000, or ($12,000 / $100,000 = .12, 12%) 12%. We’ll just assume that you never had to fix anything on the house or pay taxes, etc. A few years pass and you decide you would like to sell the house. I just happen to be in the market looking for a rental and decide to purchase the home from you for $200,000, but the catch is that the renter is still going to pay me the same $1,000 per month. So I’ll be receiving $12,000 per year on my $200,000 investment, or 6% return on my money. So a little more time has passed, and at this point maybe things start to get a little out of hand. Maybe something totally out of the ordinary starts to happen like the Federal Reserve decides (instead of bonds and MBS) to buy houses. Of course at the same time you’re looking for something to do with your money, so you decide to buy the house back from me for, let’s say, $350,000. But again, the renter isn’t going to pay you any more than $1,000 per month. So how much will your investment yield per year? $12,000/$350,000=3.42%. This is starting to sound crazy isn’t it? Well let’s fast forward to today and I am going to buy the same house back from you, but because the Fed is in the market buying most of the available real estate and driving up all the prices, the current price on the same house has skyrocketed to an astounding $500,000. Of course the same renter is in the house still and is still paying only $1,000 per month. My half million dollar investment is now only going to yield 2.4%.
Does this scenario sound crazy? I think so too and it’s a lot like what’s going on in the bond market today with the Federal Reserve buying most of the float of treasuries. But what will happen if the Fed stops buying bonds? Obviously your bonds will decline in price and the natural hedge of your asset allocation model will lose some of it’s appeal. Another problem with this is that most investors today are invested in bond mutual funds which rebalance their holdings periodically so losses will be incurred in these funds, as opposed to being able to hold the bonds until maturity. The risk and reward of investing in bonds right now makes the traditional asset allocation model that most individuals are invested in not operate as intended. If rates revert back to their historical norm of around 6-7%, bond investors will be in for some serious pain. Current yields on the U.S. 10 year are currently less than 2%. In some areas of the world right now, 10 year bonds have negative yields. As a matter of fact, approximately 25% of bonds in Europe now offer negative yields. So obviously bond prices in the U.S. can rally and yields can continue to go even lower, I even expect them to. But the real question should be: how much upside is left in bond prices and is it worth the risk?
I’m sure everyone has heard the old saying, “while history might not repeat itself, it certainly rhymes.” Alan Greenspan kept rates too low for to long largely as a result of the dot com bust and then 9/11 and the unintended consequence was the housing market bubble. Were house prices artificially too high due to low interest rates and easy credit as a result? As it turns out, yes. Is it possible that bond prices are currently too high and yields too low given the Fed’s continuing QE efforts? Is it possible that there will be unintended consequences due to the current artificially induced low interest rate environment we find ourselves in? All of the smartest economists I follow are all trying to figure out the same thing it seems- where will the unintended consequence manifest itself? Much like before the housing collapse, many people knew there were going to be repercussions of the Fed’s policies. It just took a while for the housing correction to play itself out.
To sum this up, I believe the traditional asset allocation model is broken due to the current policies of the Federal Reserve. The hedge that rising bond prices have afforded investors for the last 30+ years has largely played itself out. Sure, bond yields can continue to go down, but if they go down much further the U.S. investor will probably have larger things to worry about.
Call your FA and ask them what they’re going to do to protect your assets in a market downturn, all most people are going to hear is, “don’t worry- you’re invested in diversified portfolio of mutual funds. And if the market were to decline, well- you’re in for the long haul.” Let me translate that for you. What they’re saying is- they’re going to do NOTHING! They aren’t going to do anything because they think there job was done when they invested your money. They aren’t going to do anything because they think they’ve already done it. So when most financial advisors invest your money, they think their job is done- at Hurley Investments, our job is just beginning.
If you are concerned about the numerous risks in the market today and would like to be able to make money in any market, then contact Michael Virden @ Hurley Investment, LLC. Not only do we invest assets to make money in bullish markets, but we buy insurance and protect those assets in bearish markets.. People have insurance on everything, your house, your car, on your life, but nobody has insurance on their stocks. So not only do we make money when the market is going up like everyone else, what makes us different is when the market is going down we protect your assets and look to lower your cost basis in your shares and, at times, add shares for free. So once again, anyone can make money when the market is going up, is what happens when the market is going down that really matters.
Take care of the risks and the profits will take care of themselves.
Investment Advisor Representative