Sleeping On Expensive Financial Pillows
Summary
- In the short run, pillows manufactured in the form of bonds can feel cozy in a world of low volatility and generationally low interest rates.
- Although stocks can feel like stiff, uncomfortable pillows in the short term, in the long run, historically those stiff, uncomfortable stocks become vastly more comfortable than bonds.
- Determining your asset allocation is a monumental decision that should be driven by various factors, including risk tolerance, time horizon, income needs, taxes, and other factors such as your personal objectives.
Everybody loves a good night’s sleep and that requires a comfortable pillow. Unfortunately, many investors are overpaying for their pillows in the form of overpriced, interest rate sensitive bonds. If you aren’t careful, your retirement dreams could turn into financial nightmares.
More specifically, if the composition of your investment portfolio is overly skewed towards bonds, you stand to lose substantial amounts of money if/when interest rates and inflation persistently increase.
In the short run, pillows manufactured in the form of bonds can feel cozy in a world of low volatility and generationally low interest rates. However, investors should also ask themselves, how much longer can this unprecedented 40-year bull market in bonds last?
Interest rates approached 20% in 1980 and they stand closer to 1% today (1.24% to be more precise). What may now seem like a cozy bond portfolio may eventually lead to unnerving insomnia.
We already have negative interest rates in numerous countries around the world and inflation (a rise in general price levels) is running hot at about 5% annually. What this means is investing in a 10-Year Treasury Note yielding 1.24% effectively means you are losing almost -4% per year in purchasing power, if inflation remains at 5% (see chart below).
There are numerous investing strategies used to fight inflation, but historically stocks’ ability to raise prices through pricing power has been a useful vehicle to fend off the melting of money’s value.
Despite short-term increases in inflation, getting a good night's sleep hasn’t been an issue in 2021 as it relates to the stock market. For the month, the S&P 500 stock index was up +2.3% to a new record, and for the year it has surged +17%. The story for the Dow Jones Industrial Average looks similar – for the month rising +1.3% and year-to-date to +14%.
Thankfully, there haven’t been any night terrors yet either in the bond market. Nevertheless, short-term results have been more of a mixed bag. For the month, the iShares Aggregate Bond Market ETF (Exchange Traded Fund – [[AGG]]) rose +1.0% and for 2021 slipped -2%.
In spite of stocks being a great place to invest over the last decade or so, solely investing in stocks is not always rainbows and unicorns. The price you pay for longer-term stock outperformance is shorter-term volatility, which can be disruptive to your sleeping patterns.
Case in point, the -35% drop in the S&P 500 index at the start of the COVID-19 global pandemic when anxiety and volatility were at extreme levels. Despite the market continuously hitting new highs, investors are not completely out of the woods yet as spiking Delta variant cases threaten the trajectory of the current economic recovery.
Although stocks can feel like stiff, uncomfortable pillows in the short term, in the long run, historically those stiff, uncomfortable stocks become vastly more comfortable than bonds. Over the last five years, stock prices have dramatically outperformed bonds by +99% (S&P vs. AGG).
Determining your asset allocation is a monumental decision that should be driven by various factors, including risk tolerance, time horizon, income needs, taxes, and other factors such as your personal objectives. Therefore, even if you subscribe to the premise that stocks outperform in the long run, that doesn’t necessarily mean all retirees should load up solely on a diet of stocks.
Retirees who need income or other risk-averse investors generally can’t afford to lose substantial amounts of their net worth, if stocks tank significantly during a recession.
Not only could an all-stock portfolio not generate adequate income, an equity-heavy portfolio could also could lead to emotional sales after market declines, thereby locking in permanent losses at low levels. After these potential losses, there may not be enough time for stock losses to be recouped by retirees. If possible, most investors approaching retirement do not want to be forced to work as a greeter at Walmart to compensate for stock losses.
Everybody’s financial situation is different, and everyone has varying risk tolerances and unique needs. As such, working with an independent, experienced, and professional advisor like Sidoxia Capital Management can assist you with structuring a proper asset allocation, so your investment pillows can help you achieve a good night's sleep.
This article is an excerpt from a previously released Sidoxia Capital Management complimentary newsletter (August 1, 2021).
Disclosure: Sidoxia Capital Management (SCM) and some of its clients hold positions in certain exchange traded funds (ETFs), but at the time of publishing had no direct position in any other security referenced in this article. No information accessed through the Investing Caffeine (IC) website constitutes investment, financial, legal, tax or other advice nor is to be relied on in making an investment or other decision. Please read disclosure language on IC Contact page.
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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