There are many types of risk that your savings strategy, whatever it is, needs to address. The risk that comes most readily to mind, especially since 2008 is still fairly fresh in our memory bank, is market volatility risk. But there are other risks besides stock volatility that pose a threat to our overall savings strategy. Take inflationary risk, for example. In recent years, even with very low levels of inflation, the minimal returns on cash positions can actually be looked at as a loss when compared to how much cash it takes to purchase the same things a year or two later. Let’s take a closer look at another risk that may need to be more and more on your radar in coming years: interest rate risk.
Let’s attempt to keep this discussion in its simplest form possible, but the whole issue of how the interest rate climate in our country is affected is actually a very complex issue. Here are three things every investor should understand:
- When interest rates rise, bond prices fall; when interest rates fall, bond prices rise.
- Interest rates are primarily affected by two things: the Federal Reserve Bank raising or lowering the interest rate connected with lending money to commercial banks, and supply/demand of the fixed income open market—as investors flee from stocks to seek a safe haven, the increased demand for bonds causes bond prices to increase, and their associated rates(yield) to go down. And of course, the opposite is true when investors regain confidence and flee to stocks.
- From 1980 until the summer of 2013, our country experienced a basically steady falling interest rate environment. Since the end of the summer in 2013 until now, we have basically remained in a low level holding pattern.
Only a very small percentage of financial advisors today can claim that they have worked in a rising interest rate environment, because it’s been 30+ years since such an environment has been in play. Many investors believe that their strong investment portfolio returns in the 80’s and 90’s were all about stock returns, but not near enough credit is given to the strong, consistent returns of intermediate and long-term bond investments during that period.
Following the 2007-08 “Great Recession”, the Federal Reserve engaged in several rounds of what came to be called “Quantitative Easing” in the belief that keeping our country in a low interest rate environment would help facilitate economic recovery. In essence, the Federal Government was issuing new bonds and the Fed was turning around and buying them right back up, and the result was an historically low rate environment, although arguably artificially induced. Economists warned that one day the Fed would need to switch from one of the largest bond “buyers” to one of the biggest “sellers”, and that when they hit full sale mode interest rates, and the inflationary pressures that often times follow rising rates, could get out of control.
Based on all of the above as a premise, I would like to beg the following question: Can the traditional investment allocation approach of stocks-bonds-cash work in the same way it did for many over the last three decades plus? Will bond and cash returns be strong and consistent enough to adequately hedge the stock risk you are willing to take, keeping in mind that many believe greater stock volatility is likely to continue as we enter an age of more and more self-advising? If we move into a 10, 15, or even longer period of rising rates bond prices will likely struggle as an adequate hedge against stock market risk. To add to this, many in the financial sector believe that rising rates will not in turn cause bank savings rates to return to the levels we were accustomed to before 2008 (see recent Wall Street Journal article entitled “The Fed Raised Rates. Don’t Expect the Same for Your Bank Deposits” Mar 15, 2017).
Even if rates don’t rise as quickly, or for as long as many have warned they will, depressed rates below a more interest rate neutral level (as we’ve experienced recently) also keep longer term bond yield lower than what we need to be an adequate hedge against stock risk. We’re not suggesting you should no longer hold bond investments in the fixed income side of your overall savings approach, but we are suggesting the type and length of the bond investments you do hold needs to be analyzed very carefully. We also believe it’s time for many to consider taking a good portion of what used to be invested in bonds and consider utilizing alternative assets (assets that do not positively correlate with rising rates such as high yield bond, commodities, natural resources, etc.) and alternative strategies (conservative hedging strategies—such as some long/short strategies, some forms of cash value life insurance, etc.) as a means to enhancing your ability to adequately hedge your stock investments moving forward. We refer to “alternatives” as any place you can save other than a more traditional stock, bond, or cash position, and a more detailed look at those options/strategies are a discussion for another day.