How much risk are you taking in your portfolio?
Given the lack of return in the fixed income market and investors’ reach for yield, many are taking more risk than they should. It is traditional financial advice that the risk profile of funds set aside for retirement should vary inversely with one’s age, i.e., the older you are, the less risk you should take.
Normally, this would mean that as one ages, the proportion of equities in a portfolio would fall and the proportion of fixed income would rise.
But for the past few years, just the opposite has been happening as the Fed’s zero interest rate policy has removed return from traditional fixed-income markets and sent investors scurrying for yield, literally ignoring the risk associated with that yield.
And why not? Last year, equities returned 30 percent while traditional fixed income investments (like PIMCO’s Total Return, -1.92 percent) had negative yields. Ask yourself what would happen to your portfolio if the equity market had a sudden and major correction, say 25 percent.
Some pundits say that for the last 30 years, it has been rare for the fixed-income markets to have two consecutive years of negative returns. And while this may be true, one must question whether or not the past 30 years are a representative sample.
There was a period I remember well, 1978-1981, where the fixed-income markets produced negative returns each year. That was the period of rapidly rising and double-digit rates.
From 1981-2013, rates were in a secular downtrend. (In 1981, the 10-year Treasury got as high as 15.84 percent; in 2012, it got as low as 1.57 percent and was as low as 1.66 percent in 2013.)
It is intuitively obvious that interest rates really couldn’t go much lower, and last year we saw the first uptick, which could very well be the first of many as we switch from a long-term bull market in bonds to a bear market. (As I write, the 10-year Treasury yield is 2.70 percent.)
The reasons for this are numerous and I’ve commented on them in past columns. Here is a list:
• Experimental monetary policy has created trillions of dollars of new money now sitting in sterile bank reserves, but which have huge inflationary potential.
• Fed policy has led to a disruption of world currency markets, especially in emerging markets, and the status of the U.S. dollar as the world’s only reserve currency is waning.
• Runaway government deficits (which have exceeded $5 trillion per year on a GAAP basis for the past five years) and $90 trillion in unfunded liabilities makes inflation or oppressive taxation inevitable.
• Official inflation, via the CPI (1.5 percent for 2013), significantly understates true inflation. Using the 1980 CPI computation methodology, 2013 inflation was 9 percent-plus, according to John Williams (Shadowstats.com).
• A labor market that is much tighter than recognized (the supply of labor is those who want to work, not those who can work) and an economy unable to grow rapidly because of misplaced government policies.
Fed policy risk
As a result, I think that we will see the Fed’s asset purchases end late this year and actual rate hikes begin before the middle of 2015. (The markets are still pricing the first rate hike into late 2015 at the earliest.) Even then, the Fed, as usual, will have overstayed their easy money policy, and the consequence will be higher inflation.
What is your risk tolerance?
In this upside-down and bizarre world, what is a prudent and safe asset allocation for your portfolio?
Certainly, one must be wary of too much exposure to the fixed-income markets, especially fixed-income strategies with longer duration (maturity) structures. And while I believe that the equity markets will not collapse as long as the Fed is printing money, that game is going to end, probably sooner than the market now thinks, especially if cost-push inflation begins in earnest in the not-too-distant future, as I predict it will.
So, what is prudent?
• Your equity portfolio should consist of high-dividend-paying stocks of companies with a track record of increasing dividends and which have low levels of debt in industries that are not dependent on the business cycle.
• Yes, you should also have fixed income, but you can avoid exposure to rising interest rates through one of these techniques: 1) use inflation-protected securities; 2) employ interest rate hedges on longer duration fixed assets; 3) go to cash as rates rise.
This last concept, the holding of cash, is frowned upon by many. But if the equities markets are due for a fall and interest rates are rising, cash is the place to be. It reduces portfolio volatility (i.e., you don’t lose money) and is available for you to pick up bargains when market valuations reach extremes.
Don’t be greedy
Will equities nosedive?
The answer is “yes,” but I don’t know when. However, I expect we will see a nosedive before we see another 30 percent up year. And we have to remember not to be too greedy. By that I mean, you can’t look at your portfolio and expect it to get the returns of the equity market (S&P 500) without taking the risk inherent in the equity market (i.e., significant price corrections now and then).
You should set your sites on a consistent positive return at a level where you feel comfortable with the inherent risk.
Robert Barone (Ph.D., economics, Georgetown University) is a principal of Universal Value Advisors, Reno, a registered investment adviser. Barone is a former director of the Federal Home Loan Bank of San Francisco and is currently a director of Allied Mineral Products, Columbus, Ohio, AAA Northern California, Nevada, Utah Auto Club, and the associated AAA Insurance Co., where he chairs the investment committee.
Contact Robert Barone or the professionals at UVA (Joshua Barone and Andrea Knapp) who are available to discuss client investment needs. Call them at 775-284-7778.
Statistics and other information have been compiled from various sources. Universal Value Advisors believes the facts and information to be accurate and credible but makes no guarantee to the complete accuracy of this information.