Surprising Choices in the Search for Safety Near-Certain Loss of Purchasing Power versus Short-Term

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Risk, in its many guises, is unavoidable, and investors today are taking on significant amounts of credit risk, duration, and leverage to obtain high yields from many presumably safe bonds.  But certain types of risk are often mispriced.  By overweighting one’s portfolio to those sectors that currently offer attractive risk-adjusted returns, investors will be better positioned to meet their long-term goals.

Since the stock market bottomed in March of 2009, through the end of this past August, bond mutual funds have experienced net inflows of about $900 billion, while stock mutual funds saw net outflows of almost $200 billion. During the same period, the S&P 500 returned 123.8% (including reinvested dividends), while a 10-year U.S. Treasury bond purchased at the very bottom of the market, on March 9, 2009, earned a relatively meager 22.5%, even as interest rates fell to generational lows.

This seemingly poor asset-allocation decision on the part of many investors should come as no surprise – investors have shown an uncanny propensity over many decades for buying high and selling low. Given that yields would have to turn negative for a 10-year Treasury bond purchased today to replicate its performance of the last few years going forward, it is difficult to explain why this trend toward bonds has accelerated over the past 12 months.

The most common explanation is that investors are more risk averse than ever after having lived through the financial crisis, the flash crash, and the continuing bombardment of bad news coming from the eurozone. While likely an accurate explanation for investor’s behavior, it’s completely inadequate as a justification, because it ignores two crucial facts: all investors, even those in cash, are taking risk in some form, and all investors need to earn a high enough return on their assets to allow them to meet their goals. Buying a 10-year US Treasury at a 1.70% yield clearly won’t provide sufficient return for the vast majority of investors, so investors should be asking themselves, “Which type of risk am I comfortable taking in order to meet my goals?”