November 22, 2011
The conventional wisdom is that a portfolio of diversified asset classes will outperform a portfolio of bonds while minimizing risk. Most investors believed that to be true until the crash of 2008, when all asset classes, including U.S. and foreign stocks, real estate, mortgage securities, and commodities, crashed together. On the other hand, a portfolio of high-quality bonds held their value and provided a reliable and consistent cash flow during and after the crash. In fact, as a result of the crash the price of Treasury bonds went up dramatically. A deeper understanding of risk resulted from the crash of 2008.
The clearest analogy to cash flow from bonds is the paycheck with which most of us are familiar. A bond portfolio providing a steady stream of interest payments is like a paycheck you would receive from working. It is a defined amount that you can count on. If you had a blended portfolio of many asset classes instead, the amount you could safely withdraw would become uncertain. You could not count on a set amount unless you were prepared to invade principal in the face of down markets. Market volatility is not a problem unless you are required to sell assets when the market is declining. If you are counting on a specified withdrawal, you might quickly deplete your principal if you face years of nonexistent returns or losses, such as we experienced between 2000 and 2009. “You may need more flexibility in your spending analysis,” suggests Fred Amrein, a financial planner at Amrein Financial in Pennsylvania.
Get cash flow, not hoped-for returns
We have heard the argument endlessly that a portfolio of high-quality bonds will not pay out enough cash flow to support you in your current lifestyle after you retire. You can calculate the return on bonds and determine whether this is true. If so, you then need to decide whether you believe that some other portfolio of investments will provide higher consistent returns. You then need to evaluate the promise of high returns from this alternative portfolio and ask yourself these questions: What is the basis for your belief? How certain is your conclusion?
In psychology, there is a concept called wish fulfillment that says “I need this to be so and, therefore, it will be so.” Are you prepared to pay the price if it is not so? And how high is that price? Many investors are essentially throwing a “hail Mary pass” when they invest in stocks and other high-risk investments in the hopes of investment success. We believe that the fewer resources that you have the more conservative you should be with your investment selection because you have less room for error. Remember Richelson Investment Rule 2: If you can’t afford the risk, don’t play.
Inflation and cash flow
We are always challenged with the argument that future inflation resulting in higher interest rates will overcome the merits of the All-Bond Portfolio. But before you close the book on bonds for this reason, you need to look at the deeper meaning of inflation and then at our strategy to turn inflation and higher interest rates to your benefit.
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