Back in the Spring, I wrote a blog post about how bonds were riskier than stocks, taking into account the role that they each play in most investment portfolios. I discussed the concern that rising interest rates from such as low starting position would create havoc in portfolios. While I believed everything that I wrote, I did not anticipate just how quickly everything discussed would come to pass.
As of the close on Nov. 11th, 2022, bonds (measured by the Bloomberg US Aggregate Index) are down 14.1% for the year, while stocks (measured by the S&P500) are down 15.1%. The “supposedly” safest part of the portfolio is down almost as much as the “riskier” growth part of the portfolio! In fact, according to Vanguard, the worst year on record for bonds is down 8.1%, in 1969. This means that unless something dramatic happens in the next 45 days, 2022 will be the worst year for bond investing in the “modern investing era” (1926).
This is starting to get noticed, such as the Wall Street Journal (WSJ)article from Nov. 13th titled “The Classic 60-40 Investment Strategy Falls Apart.” Over the years, many investors have focused on 60% in stocks and 40% in bonds, which has typically performed well in just about every time period. According to the WSJ, since 1926, only two years have been worse for a 60/40 portfolio: 1931 & 1937 (think Great Depression). However, once these types of articles start to be written, I recommend thinking a little deeper to see if there is now an additional opportunity. As we tell clients, headlines tell you what already happened, not what is going to happen!
As an investor, it is tempting to be backward looking, dwelling on the most recent year or two’s performance. However, since we cannot change the markets, let’s instead focus on what we can control moving forward, particularly around the proper asset allocation.
As a reminder, our portfolios are constructed based upon forward-looking 10-year expected returns. While these are long-term projections, short-term events can change the future expectations dramatically. For example, in March 2020, our 10-year forward-looking expectations for stocks rose quickly, moving inversely to the overall stock market. Remember, the cheaper prices become (i.e. the more things fall), the higher the future returns become.
Starting now, bonds have increased their expected future returns much faster than stocks have. The best way to estimate future returns for bonds is to look at current interest rates. Take a look at the last five years for US Treasuries (2 Yr, 5 Yr, and 10Yr bonds):
Right now, bonds are more attractive than they have been in the last five years!
While this is the worst year for bonds, I calculate 10 years since 1926 with worse returns for stocks than the -15.1% as of Nov. 11th, 2022. In practice, this means that clients with portfolios closer to 60% stocks / 40% bonds at the start of 2022 may need to shift their asset allocation closer to 50% / 50% going forward to maintain a similar risk profile. In good news, future financial projections look more promising, as both stocks and bonds have higher long-term expected returns than they did at the start of the year.
Given that bonds make more sense than they did early in the year, here is our “playbook” for the coming months:
- Use excess cash to buy short-term (12 months or less) in Treasury Bonds / T-Bills. These are the safest investments and are yielding over 4%.
- Rebalance the remaining portfolio around our 10-year expected returns, which in most cases will actually mean INCREASING bond allocations, possibly even by selling some stocks.
- Continue to monitor for large moves in the market, which may lead to changes in our expected returns. For instance, if we enter a recession with stocks and interest rates falling (which means positive performance for bonds), we may look to shift the portfolio back to something similar to the start of 2022, taking some gains from bonds off the table to buy lower into stocks.
Just as I said in the article in the spring, it is important to make forward-looking, intentional decisions with your portfolio and not just rely on what has happened in the past. We do not have a “crystal ball” to predict the future, but we can position your portfolio to better achieve your investment objectives given the current environment, however it changes.