Biggest Risk To Your Investments? Probably Not Bonds

A lot has been written over the past few weeks about the U.S. bond market. Expectations are for interest rates to rise and bond prices to fall.

That would not be surprising. Interest rates have been kept artificially low for a number of years by the Federal Reserve. It would be normal for the Fed to seek to unwind such an unusual policy.

The monetary authority, in fact, has talked about doing so for many months. Only recently, however, have the fundamentals of the economy suggested that action is imminent.

So what happens next? If you own a lot of very long-dated U.S. Treasury debt, a rising interest rate environment creates the risk that you will lose money.

As rates rise, bond prices fall. You could choose to hold that bond to maturity, but it’s very likely that inflation will grow faster than the coupon pays to own those bonds. That’s why their face value will decline; the lower price compensates for lost real income.

But that isn’t really the big problem in most people’s portfolios. The typical long-term investor has bonds, but often that’s through a bond mutual fund or a bond index fund.

Those products are designed to price in the risk of a change in interest rates. A prudent bond fund is more likely to own shorter maturity bonds and will buy the longer bonds as rates go higher.

A bond index fund is designed to replicate an index, so it automatically adjusts to the new reality over time. Short of a market dislocation, such as an overnight crash, the risks are minimized.

No, the problem for most long-term investors is not bonds but cash. They own too much of it!

A recent Prudential Investments survey found that both retirees and pre-retirees hold portfolios that are about 40% stocks, about 20% bonds and the balance in cash.

Having a portfolio that’s 40% cash is massive risk, and here’s why: You need investments to beat inflation.

Generally speaking, that means you need to own stocks. Over the long haul, you can expect the stock market to return about twice the rate of inflation on your invested cash.

That happens largely because corporations must beat inflation to stay in business. It helps, too, that most investors reinvest all dividends, which creates free cash inside the portfolio above and beyond contributions by the saver.

Powerful investing

Cash is powerful in a portfolio but not if it’s not invested. If it’s just cash, then it’s losing value every day to inflation.

That means that your other investments must do much better to even keep up with the declining purchasing power of your savings.

In turn, the pressure to “win” bigger with your stock and bonds investments can lead to bad choices. Falling behind the benchmarks triggers emotional behavior and desperate trading that does not improve outcomes.

All of this activity costs money, too. Good for Wall Street. Bad for your retirement.

The better course is to make sure that you are prudently and appropriately invested for your long-term goals and to keep trading to a minimum, just rebalancing as needed, using low-cost index funds to invest.