Connecting Quarterly: 1st Quarter 2015

Dear Friends,

My wife and I have lived in the greater Phoenix area for almost 17 years.  Over that time, I’ve noticed a recurring theme:  Springtime always seems to bring increased traffic on our roads.  I’m not sure exactly why it feels like traffic levels increase in the months of March and April, but I’m confident in guessing that the legions of traveling fans from the 15 major-league baseball teams that are in town for Spring Training, spring break tourists from around the country and snowbirds waiting for the snow to melt in their home state all add up to more cars on our roads.

Earlier this March, I noticed that my daily morning freeway commute had become about 10 minutes longer overnight.   After being late for a few internal meetings during the course of that week, I thought about how I could adapt to this change in my environment:

  1. I could drive at a faster speed over the stretch of my commute where traffic is lighter, attempting to offset the additional time spent when the traffic occurs.  While there would be times that this approach would be successful, it certainly increases the potential of a disastrous accident.
  2. I could choose an alternative route and avoid the freeway.  Those of us who drive in Phoenix know that there’s almost always a combination of “surface streets” that can get us to our destination.  While this approach might make me feel better because I’d spend less time at a standstill on the freeway, it’s not guaranteed to get me to the office any quicker.  It’s longer in mileage than my freeway route, the speed limits are lower, and stoplight timing, pedestrians, bicyclists and slower trucks all have the potential to make my commute time even more unpredictable.
  3. I could take my usual route, but just leave home a little earlier.  I can’t control the number of people on the road, the speed of the truck in front of me, the timing of stoplights or other people’s need to gawk at accidents.  But I can control my departure time such that all of those uncontrollable things are less likely to influence my goal of getting to my morning meeting on time. PushThis Image

Investors today are faced with a choice that has many parallels to my traffic dilemma.  Over the past few decades, the yield investors have received from high-quality bonds and bond funds has declined significantly, to levels lower than this generation of investors has ever seen.

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Whether you are saving money for retirement, attempting to create a long-term spending plan that can be sustained throughout your lifetime, or funding a trust for your heirs, the current level of interest rates affects you.  Why?  Because history tells us that the current level of interest rates is a fairly good predictor of the future returns we should expect from the bonds we own today.   This is intuitive, because a bond is simply a loan that we as investors make to an entity or organization, with a stated interest rate that will be paid to us until our principal is eventually (hopefully) returned at a set date in the future.

Effectively, the relatively low current yield on bonds means we should expect lower returns from a balanced portfolio of stocks and bonds than we’ve experienced in the past.  Looking at the past 89 years (1926-2014), we find that the median annual return for a simple portfolio of 50% US Stocks and 50% 5-Year Treasury Bonds was 9.2%.  While the future is always uncertain, for planning purposes we believe it is appropriate for investors to reduce their return expectations going forward:

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It’s important to note that our lower future return assumption is not the result of some sort of crystal ball or forecast about what the Federal Reserve’s next action might be.  It is simply a reflection of the fact that the current yield on bonds, and thus the expected return from that portion of your portfolio, is currently at almost historic lows.

These lower future expected returns are the equivalent of expecting more traffic on the highway to your financial goals.  If your long-term plan is based on the expectation that a 50/50 portfolio will produce a 9% annual return, we believe there’s a greater chance today that you’ll fail to achieve that goal, just as more traffic means I’m more likely to be late to my morning meeting.  But, just like with my morning traffic dilemma, there are a number of options for how to adapt to the “low interest rate” environment:

  1. You could allocate more of your portfolio to stocks, and less to bonds, as stocks have higher historical and expected long-term returns than do bonds.  In some ways, this is analogous to trying to drive faster on the freeway.  It might work if I have a long-term time horizon and don’t need to take significant withdrawals from my portfolio, but it’s far from a guaranteed solution.  The greater potential losses and year-to-year swings of the stock market make it more likely that an unrecoverable event—having to sell your investment at an inopportune time—affects your long-term wealth in a negative way.
  2. You could try to increase the expected return from your bond portfolio by eschewing the high-quality bonds assumed in the assumptions above and invest instead in other types of bonds such as lower-quality high yield “junk” bonds, distressed securities, bonds issued by emerging market governments, and/or hedge funds who invest in these types of assets.  While this might make you feel better emotionally because you are taking action to try to combat the environment, these types of securities have historically shown the potential for greater short-term losses, and greater risk of default by the borrower.  Furthermore, in most cases investing in these bonds involves paying higher fees, particularly when the investor uses hedge fund vehicles.   These additional fees are analogous to the additional stoplights and slower speed limits on the surface streets of my alternative commuting route.  They all decrease our chances of success.
  3. You could maintain your targeted investment in high-quality bonds, and choose instead to modify something that (all other things equal) is certain to increase your chances of financial sustainability:  Your spending and/or legacy goals.  The two previous options involve a lot of uncertainty.  No one knows whether investing in higher-risk assets will achieve the objective of making up for the lower expected returns from high-quality bonds or, alternatively, produce a negative impact on your financial situation.  On the other hand, making even marginal changes in your spending while bond yields are low has a direct effect on the level of assets you and your heirs will have in the future.

In both navigating traffic and investing, we often want to believe that a silver bullet exists to magically improve our situation without any potential consequence.  Unfortunately, in both cases that’s simply not the case.  While some drivers and investors may choose to put the pedal to the metal and take more risk to try to achieve their goals, it seems clear to us that the alternative approaches of changing our departure time or changing our spending level is far more likely to get us where we want to go, and do so in one piece.

Of course, the best way to assess your own personal situation, and the relationship between risk and spending in the context of your own family, is to go through a detailed modeling exercise and discussion based on your specifics.  Many of our client families have participated in these discussions and we believe they are a solid foundation to a prudent financial plan.

We would be pleased to discuss any questions or comments you may have.

Sincerely,

Chuck Signature

Chuck Carroll, CFA, CAIA

Chief Investment Officer

TFO Phoenix, Inc.

 

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