(Originally posted on Not Your Father’s Financial Advisor)
One of the best questions to ask a financial advisor right now is “how should I protect my portfolio against interest rate risk?” If they can’t answer this question, run the other way. The reason this question is particularly salient is because for the first time in almost 40 years, we are facing a rising interest rate environment, with the potential for high inflation as well. This is a problem because as interest rates go up, bond prices go down, and stocks lose their inverse correlation with bonds. If I just lost you, read more about the interest rate/bond price relationship here, and read about asset class correlation here.
Since 1980, interest rates have been slowly declining (for reasons beyond the scope of this article), which means bond prices have been going up ever since and investors have been well-rewarded. But with the Federal Reserve ending their Quantitative Easing programs over the last year, and with unemployment at record lows, we are in an environment that is ripe for inflation and rising rates. In this situation, Modern Portfolio Theory (MPT) breaks down.
MPT usually has two asset classes, stocks and bonds. It assumes the latter has little or no volatility, and that the two are not correlated. Both these assumptions are wrong, unless you consider nothing but ultra-short term treasury bonds in your portfolios. When you consider the bond market as a whole, there is certainly volatility (though less than stocks), and since 1980, there has been a negative correlation. This means that when stock prices go down, bond prices go up, protecting the portfolio from extreme price movements.
This is precisely why the 60/40 portfolio (60% stocks, 40% bonds) has been so popular over that time frame; due to shrinking interest rates and low inflation, a 60/40 portfolio has experienced staggeringly low volatility while maintaining positive expected returns of both asset classes on a real, inflation-adjusted basis. In contrast, an investor with the same portfolio from 1950-1980 would barely have kept pace with inflation. The latter investor would have seen low returns with high volatility, which is something that no one wants. Whether we are entering a similar period is up for debate, but to ignore its possibility would be entirely negligent.
If not bonds, what? First, let’s make one thing clear: there is no guarantee that bonds will underperform over the next 10-30 years, so we need to keep some allocation to it. We do know that our current situation is not favorable for the asset class, so it is prudent to find alternative investments with low correlations but positive expected returns, especially in an inflationary, negative real yield scenario. There are a few alternative assets that fit that bill-
TIPS (Treasury Inflation Protected Securities)
There are reasons to have allocations to all of these, but let’s pick on gold for the sake of simplicity and because of its popularity (for a full list of asset class returns since 1972, check out this table here). Gold has very low correlation to the market, is seen as a safe haven asset (much like bonds), and performs well in negative real interest rate environments. If we replace half of the bond allocation from the 60/40 portfolio with gold (making it 60/20/20), we get a return significantly higher and lower volatility than either the 60/40 portfolio or the market alone (since the year 2000). The graphics below simulate an investor that retired in 2000 with a $1 million portfolio and began taking $50,000 annual withdrawals. Portfolio 1 represents the traditional 60/40, Portfolio 2 represents our 60/20/20 model, and the last one represents a market index fund alone.
As you can see, the index investor would have run out of money after only 16 years of retirement. Not the preferred result. The 60/40 portfolio still has more than $500,000 left and will likely last the entirety of the investor’s retirement, but rising rates may negatively impact his/her chances. The 60/20/20 portfolio has nearly 3 times the balance of the traditional portfolio, and the investor could actually afford to spend more!
I’m not saying that you should go out and move your money to the 60/20/20 portfolio listed above (gold prices actually have a more complicated story, and this portfolio would not fare well if interest rates outpace inflation), but I am saying that you should consider alternative investments to supplement your portfolio. There are a multitude of strategies to mitigate interest rate risk, but different strategies require different time horizons, risk tolerance, and experience. Never put your money in something you don’t understand, and never let an advisor do so unless he/she can explain it to you.
This article is for information and entertainment purposes only, and does not constitute investment advice. Kyle Thompson, MBA is the founder of Leetown Advisors, a fee-only financial planning and asset management firm. For further inquiries or suggestions, please email Kyle at firstname.lastname@example.org.