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Investment Advice: Is Your Crystal Ball Tuned In?

In 1952, Harry Markowitz won the Nobel Prize in Economics for Modern Portfolio Theory. Markowitz’s theories emphasized the importance of portfolios, risk, and the correlations between securities and diversification. His work changed the way that people invested and the way we advised our clients. In simplest terms, Markowitz stated that for any given risk tolerance, there is a specific combination of asset classes  (small cap, mid cap, large cap, bond, international, etc.) that will provide the highest expected return with the lowest associated risk. This is known as the Efficient Frontier.

Although there is quite a bit of fine tuning within each sector, an efficient portfolio is some combination of equity (stocks) and debt (bonds). The bond portion would increase as the client’s risk tolerance decreased. Modern  portfolio Theory has been the backbone of the investment community for over 60 years and it has done a very good job. Now, look deeply into the crystal ball of investment advice. On second thought, just look around you. What do you see?

· FINRA Issues an Investor Alert, “Duration – “What an Interest Rate Hike Could Do to Your Bond Portfolio.”
· Bill Gross, arguably the most successful bond manager ever, tweets “the 30‐year bull market in bonds likely ended April 29.”
· Warren Buffett, the “Oracle of Omaha,” was recently quoted as saying “Right now bonds should come with a warning label”

For the last 60 years we’ve been telling clients that a bond position adds safety to their portfolio – and it has. Until now, clients who own bonds today may be sitting on a ticking time bomb. Consider this; the value of any given bond is driven by the bond coupon (interest rate) and duration (time to maturity). In a falling interest rate environment, bond values will tend to rise. Since the Fed has been keeping interest rates abnormally low, clients who have held bonds for the last 10 years have done very well. On the other hand, a rising interest rate environment, will depress the value of bonds. In case your crystal ball is on the fritz, the chart below shows the potentially devastating effect of rising interest rates on a bond portfolio.

Do you have any doubt that we will see interest rates rise over the next five to ten years?

interest rate increase2

Now, imaging your clients who are desperate for yield and have purchased long term bonds. If we see just a 2% increase in interest rates, their bond will fall in price by 23%! In other words, their $100,000 bond portfolio just lost $23,000. Are they aware of this risk? Are you telling them about this risk?

I don’t mean to be a Chicken Little, but let’s take my hypothetical one step further. Interest rates rise by 2%. Clients see their bond holdings devalued by 23%. What will they want to do?

Sell! What happens to any item where there is a high supply and a low demand? The price is depressed even more. Chicken Little could be right. So why would you recommend that a client should buy (or hold) an asset that you know will lose money. Where else can you go? HIGH DIVIDEND PAYING STOCKS ON A PULLBACK ..call Patriot Advisory for a free portfolio review.

 



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