Month: September 2012

Thanks to their low risk and steady returns over the past decade and beyond, bonds and bond funds have garnered a well-deserved reputation as a safe investment in a world where little ever feels safe. That safety comes as a direct result of the inverse relationship most bonds have with interest rates.

Thus, when interest rates go down, as they have done quite steadily since the mid-1980s, bond prices go up. Because this trend has been in effect for so long, many current investors have no recollection or knowledge of a time when double-digit losses on bonds weren’t uncommon. But the time for remembering — and being prepared for change — might just be upon us.

Interest rates on bonds have recently ticked back up. A good example is the yield on the 10-year Treasury which earlier this summer went below 1.4 percent, now sits near 1.7 percent.

While still remarkably low, a continued uptick in rates could have many investors facing their first-ever negative returns on bond holdings and others recalling much rockier bond times.

Now is the time to prepare.

The good news is that bonds aren’t quite as mercurial as stocks. The wild, weekly swings that you might see in the stock market rarely happen in the bond market. That’s good news as the slow pace allows you to prepare with patience. Developing a thoughtful game plan will enable you to proactively position investments if and when a significant bond market move occurs.

Part of your plan should involve looking at your portfolio and determining which investments are at most risk if interest rates continue to rise.

Consider your mix of bonds, as well. Typically, the shorter the maturity of the bond the less fluctuation of price you will see. But if all your bond funds are long-term (20 year-plus maturities), it may be time to start thinking about moving some of that money into shorter maturity bonds and bond funds.

It’s also important to note that not all bonds react the same way to rising interest rates. Some bonds, including Floating Rate Funds, High Yield bonds, and Emerging Market bonds, are more economically sensitive than interest-rate sensitive, meaning they tend to increase in value during periods of rising interest rates. Give consideration to the nature of your bond before you do any shuffling.

You also want to look at any bonds connected to your 401k. If your 401k is loaded up on bond funds, you may want to consider a Stable Fund option. A built-in option in most 401ks, Stable Funds offer a guaranteed interest rate option. While not typically a very high rate, a low steady rate is certainly better than a negative return.

Regardless of what steps you do or don’t take, the most important thing is to simply be prepared. If the market stays steady and your bonds continue to perform, all will be well. But if things start to turn, you’ll be ready to make the changes that could secure your financial future.

On the wall in many hospital and clinic examining rooms is a chart that says, “Choose the face that best describes the way you feel”.    The chart is composed of a numerical scale that uses the numbers 1 – 10.  Number 1 is “No Pain”.  Number 5 is “Distressing Pain”.  Number 10 is “Unbearable Pain”.    Any number in between is a varying degree of pain.  Smiley faces are used as visual cues as to what kind of pain might correlate with which number.

I have sat in an examining room looking at a pain chart.  I have asked myself, “So, am I in any pain? Well, no.  But, I am just in for a physical.   Maybe that’s not a relevant question, given the purpose of my visit.”  Thinking about it a little differently, “What if I was in a lot of pain?  How, then, would I answer the question?  Well I guess it would depend on what the problem was!  I could have a sore throat.  I could have a twisted ankle.  I could be experiencing paralyzing chest pain.  Would the pain of a sore throat be the equivalent of the pain of a twisted ankle?  Let’s say that I have a horribly sore throat, and possibly only a moderately twisted ankle?  Would the pain of a horribly sore throat be the same as a moderately twisted ankle?”

Roused from my convoluted conjuring of different kinds of pain I hear the sound of the door opening and the entrance of the nurse.   After introducing herself, establishing that I really am, who I say I am – “Your date of birth please?” – she then says, and I quote, “Are you in any pain?”  OMG!

I think to myself, “You know, I do experience pain at the end of 10k run.  But that is not what she means, right?”  After taking my blood pressure, counting my heart beats, she says that the doctor will be in, in just a moment.  The doctor soon shows up and says, naturally “are you experiencing any pain?!!”  Now, hypothetically, if I did say I was in pain would he point to the “Pain Chart” and say pick a number from 1-10.”

There are endless possibilities as to the semantics of pain.  There is “My Pain”:  subjective.  There is “The pain”: objective.  And, there is the reasonable man test: what level of pain would a reasonable man have, given this set of circumstances?  “Oh, you are just such a wimp!”

Allow me to change the pain experience from physical pain to financial pain.  The classic question clients get asked is:  “What is your risk tolerance?”  Notice that one of your answers could be:  “I have no risk tolerance!”  Assuming that you have some risk tolerance, the rest of the discussion, per force, is a matter of degree.  Mr. /Mrs. Client: what if the market drops 20% would you still be sanguine about the prospects for the success of your investment?  Fair question!  Mr. /Mrs. Client:  what if your statement shows a temporary drop of 50% in the value of your account?  Would you ignore this drop in value? Or, would you get on the phone immediately saying, “Sell!”  At this moment, the client could be thinking to themself, in much the same way that I sat in the examining room, thinking to myself, “Should I be feeling any pain?  If my outlook is long term what difference does a drop in value make?  Or more accurately would a reasonable man/woman in my situation objectively have pain?”

Back to the pain chart:  sensing client frustration with the “risk-tolerance-pain” line of questioning, the financial advisor remembers his or her trip to the hospital, remembering the pain chart on the hospital wall, he/she says, “Would you pick a number between 1 -10-   1 being very conservative, and 10 being very aggressive.”  After much mental struggle, you say 5.  In a sense by picking a 5 you have established 2 things:  1. you have a moderate risk tolerance, and 2. you are willing to assume the risk that a moderate person should be willing to take.

Fast forward a few years:  the market drops 50%.  (Remember, approximately every 4.8 years we have a recession.)  Assume that you are part of a very consistent review process.  3 times a year you meet in person or talk on the phone about your portfolio.  Today is your review meeting.  The question comes up:  the recent market drop.  The financial advisor says, so you must be very happy, because you picked a number 5, a moderate risk posture, your portfolio only dropped 25%.  The silence is deafening.  Your look says it all, “What, are you nuts?  That means I will have 25% less in my portfolio to contribute to my retirement income!”   The advisor is quiet for a moment and then reaching into the recesses of his memory remembering the risk tolerance interview, he says, “I thought you were a number 5?”  Once again your look says it all, “I do not care what number I picked, I do not want to lose 25% of my portfolio!”   “Well maybe you are really not a number 5, you are really a number 3” says your advisor.  The conclusion of the meeting is that your portfolio will be changed to a #3 (more conservative) portfolio.  Some months later at the next review meeting, with the market having rebounded back 30% and your portfolio is only up 15%, same type of discussion, it is decided that you are really a #7 (more aggressive)!

What is behind the pain chart madness?  My opinion is that your portfolio is no longer your rainy day money, your “ace in the hole”.  Your portfolio is your everyday money.  Your money must be safe every day.  Your money must grow every day.  Most people approaching retirement do not have the luxury of having a pension.  The financial foundation of those who retired in the early 1990’s was social security and a pension.  The trend today is: no pension.  401ks, 403bs, SEPs, Simple plans and other defined contribution plans promise only that you can contribute.  There is no promise as to what the results will be.  At the very moment that you crave stability, retirement, your retirement, is based on a murky market future.

Our objective at Minich MacGregor Wealth Management is to bridge the gap between the pain chart and the murky market future.