If you are like the typical investor in recent years, you have been very happy with your bond portfolio.
The chart below from Charles Schwab dramatically illustrates how widely the love affair with bonds has spread. You are looking at the net inflow of cash into domestic stock mutual funds versus total bond mutual funds from 2008 through most of 2012.
Here is the most obvious reason for this investor behavior: We all love winners. Americans want to sink their precious dollars into investments that are generating the best performance numbers.
The fixed-income stampede has corresponded with a declining interest rate environment resulting in impressive returns for bonds, which have historically offered investors lower risk with lower returns.
During the past five years (as of Feb. 1), however, the bond market’s total return as measured by Barclays U.S Aggregate Bond index has generated a yearly total return of 5.40% versus a 3.93% annual total return for Standard & Poor’s 500 Index.
Investors’ desire to back the winners, by the way, is perfectly understandable and often makes sense for other consumer choices. For instance, if you were embarking on a cross-country trip and had to choose between driving a new fully loaded 2013 Lexus or a 1999 Volvo station wagon with 199,000 miles, the choice would be easy. You’d be much more likely to reach the East Coast driving the Lexus.
Investing, however, is different from buying a car, the latest electronic gadgets or a well-marbled New York strip steak.
When investors chase the best-performing investments of the moment, whether it be bonds, stocks or something else, they are injecting more risk into their portfolios. High-flying investments, after all, eventually return to earth with lower returns going forward.
So how do we, as investors, protect ourselves from our natural inclination to always back the latest winners? Here are three ways:
At Dowling & Yahnke, we help clients by building portfolios that best fit their long-term investing goals and risk tolerance. Some clients hold more bonds than stocks in their portfolios, but this allocation will be based on their long-term goals, not on what’s happening right now on Wall Street.
If a client’s target asset allocation, for instance, is a 60/40 split of stocks and bonds, we stick with that allocation through disciplined rebalancing.
After the extended bond rally, rebalancing would have involved selling some bonds (or not buying more bonds) (winners) and buying more stocks (losers). Admittedly this can be a painful exercise, but it makes financial sense.
In this exercise, investors who followed a disciplined rebalancing strategy sold their excess bonds at relatively higher prices and bought stocks at relatively cheaper prices.
The beginning of 2013 has been a great time for stocks, which may make investors who hated shedding some of their bonds last year feel pretty good right now.
The best way to avoid getting caught up in the financial media hype is to ignore the daily press coverage of the markets. A principal at Dimensional Fund Advisers has called this breathless media coverage “financial pornography” and we couldn’t agree more. Investing is a long-term process.
We follow the financial press to stay informed and understand the long-term trends in the markets, but we don’t make investment decisions based on the news of the day.