Timeless Wisdom on Fixed Income Investing

August 1, 2013


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There’s been a lot of talk about bonds lately, with a lot of trading to go with. This current buzz makes it a good time to revisit the timeless role that fixed income investing plays in a diversified portfolio. The bottom line: For both stocks and bonds, market seasons come and go, sometimes hot, sometimes cold. None of us can forecast the precise outcomes. But across time, historical evidence provides us with a set of guiding rules to help us chart our way across the years.

Guiding Rule #1: Invest According to a Sensible, Customized Plan.

When you embark on an investment strategy, a good way to begin is with a deep exploration of your personal circumstances, to determine the levels of investment risk you could or should accept in pursuit of your financial goals. Next, we suggest crafting an Investment Policy Statement (IPS) to guide the way. Only then do you consider specific investments for your portfolio, including determining an appropriate balance between stocks and bonds.As a result, your stock-bond allocations are closely tied to you and your needs. They’re also based on the available evidence on how markets are expected to deliver their long-term returns. In contrast, current headlines are based on predicting events over which we have no control. While there is no guarantee that your well-planned portfolio will deliver the outcomes for which it’s been designed, we recommend you stick with it, ignoring the temptation to react to near-term news. A carefully crafted portfolio continues to represent your best odds for achieving your personal goals.

Guiding Rule #2: Bonds are safer; they’re not entirely safe.

We frequently and repeatedly advise our clients to “stay the course” during troubled times. Still, in the face of each new period of market risk, it’s human nature to wonder whether, this time, it’s different. This may especially be the case when bond markets are out of favor; perhaps we’ve grown used to thinking that bonds will keep plodding along reliably, if unspectacularly.This is close to, but not quite accurate. Compared to stocks, bonds have historically exhibited lowermarket risk (uncertainty) along with commensurate lower returns. But they have exhibited somemarket risk, along with some expected returns.Consider the roles for which each asset is intended. You invest in stocks to help build new wealth over time. Bonds are meant to dampen the bumpier ride that stocks are expected to deliver over time, while contributing more modestly to your portfolio’s overall expected returns. In the face of inflation, cash is expected to actually lose buying power over time, but it’s great to have on hand for near-term spending needs.

Thus, in performance and predictability, fixed income is meant to be “cooler” than stocks, but “warmer” than cold, hard cash. Based on its in-between role, we actually expect fixed income to periodically deliver disappointing returns, sometimes even for extended periods. These periods are expected to be less severe and less frequent than you’ll see in your stock holdings … but they exist. They need to, for fixed income to fulfill its intended role.

Guiding Rule #3: Act on What You Can Control

So, where does that leave you if you want to be a long-term investor, diligently adhering to your carefully wrought strategy? There are some possibilities we can help you explore.Are your fixed income holdings the right kind? So far, we’ve spoken of fixed income as a single pot. In reality, just as there are various kinds of stocks, there are various kinds of bonds, with different levels of risk and expected return. Because the goal here is to preserve wealth rather than stretch for additional yield, we typically recommend using high-quality, short- to medium-term bonds for your fixed income allocation. If you have fixed income holdings that may not fit this description, we can help you analyze these assets and determine whether changes may be warranted.How are your own goals and risk tolerance holding up? Periods of market uncertainty may cause you to second-guess portfolio choices you made during calmer times. During uncertain markets, you might begin to feel your portfolio is no longer performing as hoped for, or you simply don’t feel prepared to continue tolerating market risk once it’s arrived. When that is the case, we can first help you take a look at the numbers before you leap.You may be pleasantly surprised by the assessment. Alarmist headlines have a way of generating levels of fear and pessimism that may not be warranted. Or, if your portfolio isn’t in line with your personal goals or true risk tolerances, we can help you plan for cost-effective adjustments along a sensible timeline.Time for a rebalance? If it makes sense for you to remain invested according to your existing plans, various market conditions may warrant a rebalancing. As the markets shifts around over time, your investments tend to stray from their original, intended “weights” or allocations. Rebalancing is the act of shifting those allocations back to where they belong, at or near your personal target goals. The goal is to do so effectively, but also cost- and tax-efficiently.

Guiding Rule #4: Be Brave.

More than four centuries ago, Galileo Galilei is attributed to have said: “All truths are easy to understand once they are discovered; the point is to discover them.” He also was accused of heresy and placed under house arrest for the remainder of his life after he observed that the earth revolves around the sun.Galileo’s experiences offer an early illustration that there’s a big difference between understandingand accepting best available evidence in an uncertain world. In many respects, investing is a scientific endeavor. But there are times when it requires courage and perseverance to remain confident about that evidence, particularly when others are succumbing to irrational doubts. We’ve said it before, and we’ll say it again: Stay the course.