Fixed income returns can be volatile. When they will go up, as well as how much and how quickly, is anybody’s guess.
Instead of expending valuable energy on perennial uncertainties, you should take a more practical approach to managing your portfolio. This goes for the fixed income and equity portions alike. Focus on optimizing components that are more readily within your control. Here are four rules to help keep your focus in check and keep the stresses of investing at a minimum.
Rule #1: Develop a Detailed, Sensible Plan
Undisciplined investors are controlled by unknowable events over which they have little control. Investing may not come with a guarantee that you’ll accomplish your goals, but that doesn’t mean you shouldn’t have a plan.We believe a well-developed investment plan represents your best interests and your best odds for achieving your personal goals.
That’s why there’s one principle that drives all the rest: Have your own detailed investment plan – preferably in the form of a written and signed Investment Policy Statement. If you have a personalized plan, you have a touchstone for any and all investment decisions you make, including building and maintaining an appropriate balance between stocks and bonds, as well as determining what to include in your bond portfolio.
Rule #2: Study the Evidence
With your personalized plan in place, a good next step is to embrace the mountain of empirical evidence that helps us understand the overarching roles for which each investment is best suited.
Stocks – Stocks are the most effective tool for those seeking to accumulate new wealth over time. But along with higher expected returns, they also expose us to a much bumpier ride (volatility), and increased uncertainty that we may not ultimately achieve our goals (market risk).
Bonds – Bonds are a good tool for dampening that bumpier ride and serving as a safety net for when market risks are realized. They can also contribute modestly to a portfolio’s overall expected returns, but we don’t consider this to be their primary role.
Cash – In the face of inflation, cash and cash equivalents are expected to actually lose buying power over time, but they’re 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:
|Expected Long-Term Returns||Highest Purpose|
|Stocks (Equity)||Higher||Building wealth|
|Bonds (Fixed Income)||Lower||Preserving wealth|
|Cash||Negative (after inflation)||Spending wealth|
By keeping your attention focused on these larger principles of stock/bond investing, it becomes easier to prioritize. For example, you can recognize that, even when your bond holdings are plodding along compared to the rest of your portfolio, the more important consideration is whether they are fulfilling their highest purpose in your total wealth management.
Rule #3: Understand the Difference Between Stocks and Bonds
To further maintain your financial resolve in the face of complex and often conflicting fixed income news, it may help to understand that, compared to stocks, bonds have historically exhibited lower volatility and market risks, along with commensurate lower returns. But they do exhibit some volatility, as well as some market risk.
Because bonds represent a loan as opposed to an ownership stake, they are subject to two types of risks that don’t apply to stocks:
- Term premium – Bonds with distant maturities or due dates are riskier, so they have returned more than bonds that come due quickly.
- Credit premium – Bonds with lower credit ratings (such as “junk” bonds) are also riskier and have returned more than bonds with higher credit ratings (such as government bonds).
When reading bond market headlines about interest rates, yield curves, credit ratings and so on, these are the two risks and commensurate return expectations that are rising or falling along with the news.
As such, bond market news may be alarming or exciting at times, but it’s not as volatile when compared to stocks. The levels of volatility and degrees of risk in bonds need not – and really should not – be as extreme as we deal with in equity/stock investing to pursue higher expected returns. The decisions you make about the risks inherent to your bond holdings should be managed according to their distinct role in your portfolio, as we’ll explore next.
Rule #4: Focus on What You Can Control
So, where does all this leave you, the long-term investor who is diligently adhering to your carefully crafted strategy? Answering these three questions can help you appropriately position your fixed income investing to withstand varied market conditions:
Are your fixed income holdings the right kind and structured according to your goals? Just as there are various kinds of stocks, there are various kinds of bonds with different levels of risk and expected return. Because the main goal for fixed income is to preserve wealth rather than stretch for significant additional yield, we typically recommend turning to high-quality, short- to medium-term bonds that appropriately manage the term and credit risks described above.
Are you keeping an eye on the costs? One of the most effective actions you can take across all your investments is to manage the costs involved. When investing in bond funds, this means keeping a sharp eye on the expense ratios and seeking relatively low-cost solutions. For individual bonds, it becomes especially important to be aware of opaque and potentially onerous “markup” and “markdown” costs. While these costs don’t typically show up in the trade report, they are very real, and can detract significantly from your end returns.
Are your solutions the right ones for the job? Whether turning to individual bonds, bond funds or similarly structured solutions such as Certificates of Deposit (CDs), your fixed income portfolio should strike a harmonious balance between necessary risks and desired returns – within the context of your own plans and according to the distinct role that fixed income plays within those plans.
Achieving the Balancing Act
To achieve this delicate balance, it can make good sense to seek the assistance of an objective advisor to help you weigh your options, determine a sensible course for your needs, and implement that course efficiently and cost effectively.
Your advisor can also help you revisit your plans whenever the markets or your own circumstances may cause you to question your resolve. Should you stay the course? Are updates warranted? It can help to have an experienced ally to advise and inform you before making your next moves.
What This Means for You
In short, it remains good advice to invest according to what decades of empirical evidence has to say about earning long-term returns and mitigating related risks. That means not putting too much stock in what the headlines are screaming at you. It means observing and minimizing costs. It means focusing on your personal goals, and on ensuring that your portfolio is optimized toward achieving those goals – today, tomorrow and over the long haul.
Create a portfolio that reflects your personal goals. Contact McLean today.
McLean Asset Management Corporation (MAMC) is a SEC registered investment adviser. The content of this publication reflects the views of McLean Asset Management Corporation (MAMC) and sources deemed by MAMC to be reliable. There are many different interpretations of investment statistics and many different ideas about how to best use them. Past performance is not indicative of future performance. The information provided is for educational purposes only and does not constitute an offer to sell or a solicitation of an offer to buy or sell securities. There are no warranties, expressed or implied, as to accuracy, completeness, or results obtained from any information on this presentation. Indexes are not available for direct investment. All investments involve risk.
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