You have heard of the importance of owning a diversified portfolio. For those who do not manage money professionally, the mantra to diversify by investment class is pounded into their heads by the consumer finance media and is rarely questioned.
The reason bonds are included in a balanced portfolio is usually to reduce the overall risk characteristics of a portfolio. For example, if an investor would be panicked by a short term 20% drop in the value of their holdings as reflected in their monthly statement, then we can add maybe 40% to the bond side making it likely that a 20% drop in stock prices will only result in a 12% drop for that investors statement (.6 allocation to stocks X .2 short term drop in value). It is not that bonds offer superior returns; it is that bond returns are usually not correlated with stocks and fixed income returns are usually less volatile than stock returns. The same reduction in risk can be achieved by holding cash and money market funds, but historically bonds have outperformed cash.
Yet when markets enter periods of extreme turmoil like 2008 and 2009 the usual correlations of investment returns fly out the windows and bonds can tank at the same time stocks tank. Another risk to owning bonds is the inverse relationship of bond prices to interest rates; if interest rates rise bond prices will fall.
So my question to you is: Why do you own bonds. Are you afraid of the temporary drops in stock prices or are you just following the mantra of the popular press? With interest rates poised to rise would you be better off using cash as a buffer?
The Beloit College Mindset List began in 2004 as a way for the faculty to have a frame of reference for understanding how the incoming freshmen view the world. It lists technological and cultural experiences that are unique to the young men and women attending classes. In that vein we offer the Retirees mindset list, to perhaps help younger people understand the mindset of today's retirees.
Today's retirees, age 65, were born in 1951, the year color TV first broadcast and the year the first oral contraceptive was released. UNIVAC, the first commercial computer was built and Super Glue was born.
They started grade school in 1957, the same year the first satellite, Sputnik was launched and Velcro was patented.
They graduated high school in 1969 when the first man set foot on the moon and in what would one day become an even bigger technological achievement, ARPANET, the precursor to today's Internet went live. It was the same year thousands marched in opposition to the war in Vietnam, Wal-Mart was incorporated and the most epic concert in history took place in Woodstock.
They probably bought their first home around 1976 when the average house cost just over $43,000 and the average mortgage rate was about 9%. Apple Computer was formed and the inkjet printer was invented.
They have lived through a dozen Presidents, seen the three wars and thirteen military incursions, they have gone from a phone on the wall to a phone in their pocket and from typewriters to Wi-fi.
The things you take for granted today would have seemed like magic when they were born. So if your Mom or Grandpa is sometimes perplexed by the latest gadget, cut them some slack and help out without such a smirk on your face.
I saw “The Big Short” this past weekend. It was better than I expected and depicted the madness of crowds and greed run amok.
While most will see the movie as an indictment of bankers and Wall Street, they will be missing one of the most important lessons from yet another financial crisis.
The problem that led to the mortgage meltdown wasn’t just that banks made many, many bad mortgage loans, the ultimate cause was once again leverage. Archimedes is famous for his quote about using a lever to move the earth, "Give me a place to stand on, and I will move the Earth." Leverage in finance speak means borrowing and Wall Street’s version of this quote is “Give me enough leverage and I will ruin any economy”
All economic bubbles and subsequent crashes can be traced at their root to too much leverage in the economic system. The Tulip Mania of the 1860’s resulted from what was futures contracts with no margin requirements. The stock market crash of 1929 was a direct result of too much leverage in the markets where a dime could control a dollars’ worth of stock. The Long Term Capital crisis of the late 1990’s was a result of too much leverage. If you can identify where leverage has gotten out of control you can predict and profit from the next bubble.
So looking around the world today where has borrowing gotten out of hand?
China comes immediately to my mind. Public and private debt (and it is really, really hard to distinguish the two in an economy directed by a central committee) has ballooned to over 28 trillion dollars or about 300% of the nation’s total GDP. China has built shopping malls where no one shops and entire cities where no one lives. In the US these developers would be bankrupt in short order, but in China things just seem to move on as if this is a normal way to do business.
Making matters worse, China is committed to being considered by the world as a stable economic powerhouse. Although a fall in the value of the Renminbi would spur exports and help the Chinese economy, the ruling class is opposed to any move that would make them look to be anything but brilliant. As if they believe they can control everything indefinitely they recently warned investors and George Soros in particular that shorting the Renminbi would result in economic ruin. Ha! Even after spending over $500 billion of their foreign currency reserves to support the currency, outflows continue to pressure the Chinese economy.
Markets are self-correcting and the world economy is big. Do not believe the Chinese can distort the markets indefinitely.
The old prayer goes…”God grant me the serenity to accept the things I cannot change, the courage to change the things I can, and the wisdom to know the difference.”
You cannot change the markets; they have a life of their own. But you can change the way you see them and the way you react to them. Enter with caution, have the courage to stay. Know that your fear is usually irrational and have the wisdom to overcome your panic. Patience will bring the serenity.
Sometimes it happens. Someone comes into my office wanting to know about their investments and how we manage money but doesn't want to go through the financial planning process. The have done their own planning or don't want to do the work to build a real plan.
That's like going to the doctors office and saying, "Write me a scrip".
It won't happen. That is not how medicine is practiced or how financial planning is done.
It is always amazing how stock market tops attract so many investor dollars. Just when things are at their riskiest point flows of funds into stocks skyrockets. We convince ourselves that the part will last forever and we hate being left out.
The flip side is the head scratcher of a down market, where no one wants to buy even though prices are marked down 10%, 25% or even 50% on rare occasions. If this were a department store the aisle would be overflowing with bargain hunters. Yet when it comes to investments no one wants to shop the markdown rack.
If you are feeling confident you should stop and think deeply about why. If you are feeling scared, then it is likely time to go shopping.
"That s**t’s bananas, YO."
That is my favorite line from Shaun T's Insanity workout videos. And that is how the stock market seems sometimes. Just plain crazy.
But like Insanity, if you stick with it you will reach your goals. It's not easy but it works.
Discipline is your friend. It keeps you doing things that are good for you, like going to the gym or saving a portion of each paycheck. It gives you a framework for living so you won’t panic if something goes awry. It gives you direction so you will stay on track in all your endeavors.
The armed forces instill discipline to be sure each new recruit will work with the team and be effective even in life and death situations.
You can become more disciplined simply by practicing. Today you can skip the doughnut and have a salad instead. Today you can put an extra $5 in your savings account. Today you can take the stairs rather than the elevator, Practice, practice, practice. Then it becomes natural, a part of who you are.