Interest Rates and Your Financial Future

Blog post #462

Interest rates have been quite low for over a decade and are not likely to increase in the next few years. This has important implications for all investors.

The 10-year US Treasury bond yield has been below 4% since 2008, in the 2-3% range for most of 2009-2019, and has been well below 1% since the Covid pandemic hit in March of this year. (see the chart below).

The Federal Reserve on Wednesday provided forward guidance that they project short-term interest rates to remain near zero well into 2023. Eventually they predict short-term rates of around 2.5%, but they do not provide any guidance as to when that may occur. While their forward guidance (projections) have generally not been accurate, they are basing these predictions on the impact of Covid on the economy and the lack of current and expected future inflation.

What is the impact of continued low interest rates mean to you?

When we do investment planning for you, one of the most important decisions is how much to allocate to stocks and how much to allocate to fixed income (bonds, CDs, bond mutual funds, cash, etc.).

This high level asset allocation decision is based on several factors, which include your need and willingness to take risk, how much growth you need from your investments to meet your financial goals and your investment timeframe.

As we review these items with you, that will guide our recommendation of how much of your portfolio should be in stocks and how much should be in fixed income.

The key concept that we want to stress is that even though interest rates are very low, and may remain that way for a while, this should not significantly change how much you should allocate to fixed income. 

Why? Shouldn’t the prospect of continued lower interest rates make someone want to increase their stock allocation, as the fixed income returns will be very low? Let’s look at some examples and discuss this further.

If you are in your 20s or 30s and have decades of work and savings ahead of you, we may recommend a stock allocation of 80% or even more.

If you are in your 40s or 50s and need growth from your portfolio to provide for the retirement you desire, your asset allocation may be 60-70% in stocks, with the remainder in fixed income.

If you are in your 70s or 80s and have saved enough so that you can live comfortably, your stock allocation may be well below 50%.

We don’t think the prospect of continued very low interest rates should materially change your overall asset allocation plan because most people don’t want to significantly increase their stock market risk more than they need to.

If you feel that because of expected continued low interest rates you should decrease your fixed income allocation and increase your stock exposure, you must be prepared for the increased volatility (short term risk) that comes with owning more stocks.

Fixed income provides you with some income, but we view the fixed income allocation primarily to provide stability to your portfolio. Thus, you don’t have as much temporary volatility that comes with owning stocks. If you have the stomach to own more stocks, and can handle the swings and volatility, then your expected returns could be much greater over the long-term, say 10 or more years. But for most investors, they need the ballast of fixed income in their portfolio.

As we remind clients, it is normal for stock markets to decline at least 20-30% every 3-5 years. That is the type of temporary volatility that is to be expected in order to earn the long-term rewards of owning stocks.

  • If someone had a $2 million portfolio with a 50% stock / 50% fixed income portfolio, they would have $1 million invested in stocks. If that portfolio incurs a 35% decline, as happened in the S&P 500 earlier this year, the stocks would decline by $350,000.
  • But if the stock allocation had been increased to 75% because of lower expected interest rates on the fixed income allocation, they would have had $1.5 million invested in stocks. If a 35% stock market decline occurred, the temporary decline would be $525,000, which is far greater than the $350,000 temporary drop of a 50/50 portfolio.

The question you must ask yourself: Is the additional volatility of the stock market worth the increased exposure to stocks? Will you be able to maintain a higher stock market exposure through the down periods? This is so important, because the worst result would be to increase your stock market exposure now, then panic when a major stock market decline occurs.

We plan to remain consistent with our long-term principles regarding fixed income.

  • We will only invest in high quality fixed income, as the return of your principal is most important.
  • We will not reach for yield by buying junk bonds. If a bond fund says high yield, that means it is holding less than investment grade securities, which have a much greater chance of defaulting. We don’t recommend junk or high yield bond funds for our clients.
  • Diversification is vital in fixed income. For those who invest in municipal bonds, we recommend holding bonds of many states, not just your home state.
  • We regularly monitor your fixed income holdings of corporate and municipal bonds for any downgrades or credit risk exposure. We would rather sell today than take the chance on a default in the future.

The financial world is continuously changing. We are here for you, if you have any questions about this or other financial matter. 

We would be pleased to assist you, your family members and friends.

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Investing for Long Run

Blog post #461

We invest for the long run. For long-term financial goals like college and your retirement.

Think of your investment horizon as nearing and then crossing a bridge, such as the Mackinaw Bridge or Golden Gate Bridge.

The investment horizon while you are saving is the period while you drive towards the bridge.

When your kids enter college or you near/begin retirement are comparable to after you have crossed the bridge.

These are serious financial goals and we make our investment recommendations accordingly. We don’t take unnecessary risks. We diversify. We recommend building a globally diversified portfolio that contains thousands of stocks, across industry sectors and geographic regions. We invest in large and small companies, in the US and across the globe.

As we build your portfolio, if you consider it like driving over the bridge, we think it is better to drive in the middle (having a broadly diversified portfolio) than riding the edges of the bridge with no guardrails (owning few stocks or very risky stocks concentrated in one sector or region).*

 

Why do we structure our portfolios in this diversified manner? Wouldn’t it be better to just load up on high tech stocks? Because the less diversified you are, the closer you may get to the edge of the bridge. Sometimes, this can mean higher returns, but it also may mean greater losses. Owning huge positions in individual stocks can lead to large losses which are unnecessary and hard to recover from.

With a globally diversified portfolio, you will have fewer reasons to worry about poor returns from a single stock or asset class. This does not mean that we recommend 50% or more outside of the US. We generally recommend holding 20-30% of your stocks outside of the US, depending on your personal circumstances. Because there have been many time periods in the past when non-US (International stocks) outperform US stocks for long periods of time, we feel this is prudent in the long-term. And that will keep you in the center of your financial road.

As you approach a bridge, there is frequently a backup. You are stuck in traffic. You may want to change lanes to get in the best toll booth lane. But once you switch lanes, your new lane becomes the slow lane. If you keep changing lanes, you will usually get more and more frustrated.

Investors do similar things. They can be impatient. They may want to get out of the stock market when the road gets scary. They may want to eliminate certain sectors of the stock market from their portfolio (such as small value and International stocks) because they are underperforming other asset classes, even though long-term historical data shows that they outperform or add important diversification benefits over long periods of time.

While we do not have a clear roadmap of the future, we feel that being disciplined and relying on historical financial evidence is better than guessing and continuously changing lanes.

We provide you with objective, rational advice. We do not give in to panic or make hasty, emotional decisions.

For most of us, whether crossing a bridge or investing, we want to follow a safer and prudent path. Your future is too important to risk.

Talk to us. We want to listen. We want to assist you, your family members and friends.

 

Source:  *27 Principles Every Investor Should Know, by Steven J. Atkinson (Illustrations by Dan Roam) July 2019

It’s Hard to Stay on Top

Blog post #460

The Covid outbreak has caused each of us to adapt and change.

Adapting and dealing with change is not a new concept. In order to succeed over a long time period, organizations and companies must adapt and change to remain on top.

Very little stays constant. We know that change happens over time. Sometimes change is gradual and sometimes it’s sudden. Change can happen for many reasons.

Companies that are successful over long periods must be able to adapt and change, or they will be less successful or less profitable or shrink and possibly even go out of business.

The chart below shows the top 10 US stocks based on market capitalization by decade from 1930 to 2020. The data is based on their overall stock market value at the end of the calendar year, preceding the decade. For example, for 2020, Apple was the largest stock based on market cap as of December 31, 2019 (see the far right column, at the top).

Suggestion….if you can look at this chart on a device where you can enlarge it, the chart is much more informative.

Key takeaway: While some companies remained in the top 10 list for decades, this chart shows how much change there has been over the long term and how hard it is to remain in the top 10.

Based on this past evidence, it is hard to know with confidence if a top 10 stock today will be a top 10 stock in 2030 or 2040.

Exhibit 2, from DFA Article, “Large and In Charge? Giant Firms atop Market Is Nothing New”.

Some observations from this chart:

  1. From 2000, only 2 stocks that were in the top 10 are still in the top 10 as of the beginning of 2020. That is a significant amount of change in 20 short years. What 2 companies do you think these are? Think about this.  The answer is at the bottom.
  2. Apple was not in the top 10 until 2010. It is now #1.
  3. Of the top 10 in 2020, 5 of those companies were not in the top 10 at the beginning of 2010. That is an amazing amount of change in 10 years. And since the beginning of the year, JPMorgan would be out of the top 10 today, and either Tesla or Walmart would be #10. Tesla was far from the top 10 at the beginning of the year.
  4. What decade did Amazon begin in the top 10? The answer is at the bottom.
  5. What stock was in the top 10 every decade from 1930 through 2010, was #2 at 2000, but dropped out after 2010 and is now only about 110-120th largest as of June 30, 2020? General Electric.
  6. The chart by decade shows how the economy and world have changed significantly.
    • Energy stocks were 5 of the top 10 in 1980. There are no energy stocks in the top 10 now.
    • There were 5 technology stocks in 2000 (Microsoft, Cisco, Intel, Lucent and IBM) and 5 technology stocks on the list at the beginning of 2020. However, only Microsoft remains on the list from 2000 to 2020. And none of the other 4 stocks have done well in the 20 years since 2000, compared to the S&P 500 index.
      • Today’s leaders may not be the leader’s a decade or two from now.
      • To show how hard change is, Cisco was #3 in 2000. Its current price is still lower than it was at December 31, 1999. In 2007, Cisco purchased a company called WebEx, a web conferencing start-up. In 2011, a VP of Engineering pitched an idea for a smartphone-friendly conferencing system to Cisco executives. They rejected the idea and Eric Yuan left to establish Zoom Video Communications, which is now worth over $100 billion. Cisco is worth about $174 billion but could be worth so much more.
    • Since 1990, it appears that change is even more frequent, or that is even harder to remain in the top 10 list. At the beginning of each decade, these are the number of companies that appear on the list for the first or only time:
      • 1990:  4 companies
      • 2000:  5 companies
      • 2010:  1 company
      • 2020:  5 companies

While many of the current top stocks have performed extremely well in recent years, you should remember that expectations about future operational performance of a company should already be reflected in it current price. Positive developments that occur in the future that exceed current expectations (such as Covid’s positive impact so far on Amazon and Walmart) may lead to further gains in its stock price. However, unexpected changes are not predictable.

Historical data on the performance of the top 10 stocks following the year in which they joined the list of the 10 largest firms shows much less positive results. As Exhibit 3 below shows, these stocks outperformed the total stock market (this is not compared to the S&P 500) by 0.7% per year in the subsequent 3-year period. Over the subsequent 5- and 10-year periods, these stocks underperformed the total stock market on average by greater than 1% per year. This data was compiled for each calendar year between 1927-2019, not just by decade in the prior chart.

 

 

The only constant is change and this clearly applies to the dominant stocks in the market. It remains impossible to systematically predict which large companies will outperform the stock market and which will underperform it. This reminds us of the importance of having a broadly diversified portfolio that provides exposure to many companies and industry sectors.

Answers from above:

1. Microsoft (#1 in 2000, and #2 at the beginning of 2020) and Walmart (#4 in 2000 and #9 at the beginning of 2020).
4. Amazon was not in the top 10 in 2000 or in 2010. The first decade that Amazon appears in the top 10 was in 2020, ranking #3 at the beginning of 2020.

 

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