Low yields justify portfolio allocation tweaks

As published in the Minneapolis Star Tribune 6/19/2021.

Traditional asset allocation models suggest that as investors get older (and wealthier), it’s appropriate for their investment portfolios to become less risky. That usually means more money in conservative assets such as bonds and cash. But in this new economic reality where bond yields are low, cash yields are gone and inflation is accelerating, maybe what portfolios need is less historical modeling and more common sense.

Mutual funds that track the Bloomberg Barclays US Aggregate Bond Index yield around 1.3% per year. Most international bond funds yield even less. The majority of bond funds have negative year-to-date returns after factoring in rising interest rates.

Exceptionally low bond yields are nothing new. The Fed has been printing money and buying bonds for most of the past decade. What is new: Inflation is increasing at the fastest pace since 2008.

As of mid-June, the U.S. Labor Department’s Consumer Price Index had risen 5% from a year ago. Meanwhile, the “safe” assets in many portfolios have gained much less, and in some cases declined, over the last 12 months. Does this sound like an environment in which you want to invest more money into bonds?

Please don’t construe this as an argument against diversification. Modern Portfolio Theory taught us that different types of investments when paired together can maximize long-term returns for a given level of risk. For most of us, however, being diversified means owning some combination of the three major asset classes: stocks (equities), bonds (fixed income) and cash. Stocks, as you may have heard, have been on a pretty good run the last 15 months. The other two? Not so much.

What else, then, should investors consider if they are willing to tweak their allocation?

More equities is one solution, but with the S&P 500 having already gained 85% off its March 2020 low, throwing more dollars at the benchmark’s most heavily weighted companies is not something we recommend. A better strategy is diversifying within equities.

If your stock exposure is 100% passive, consider complementing it with an actively managed strategy. Own five times more U.S. stocks than international? Maybe it’s time to adjust that ratio. If your funds are entirely market-cap weighted, add an equal-weighted component. Be mindful of dividend-payers vs. growth stocks and how much you have invested in each.

As for other asset classes, several are worth considering. Gold has historically been a legitimate hedge against inflation and is uncorrelated to both stocks and bonds. It’s worthy of at least a small slice in most portfolios. Publicly traded real estate investment trusts (REITs) are a convenient way to access nonresidential real estate and different geographic regions. In terms of volatility, these behave similar to stocks.

Most investors should steer clear of hedge funds and alternative strategies, which carry high fees, limited transparency, low liquidity, or all of the above. Cryptocurrencies may eventually mature enough to be considered, but their volatility keeps them out of our comfort zone for now.

Junk bonds (those rated below BBB) yield less than ever in absolute terms, but a strong economy also reduces default risk. For some, more high-yield and a bit less in traditional bonds may be appropriate.

If nothing else, low yields should reframe your perspective. Investors either need to accept lower overall returns or be willing to take more risk.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.

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