Here’s a portfolio gut-check you can perform yourself
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Hey, did you hear? The stock market crashed. OK, you know that already. However, you might not be as familiar with some related, but less obvious risks that have yet to fully reveal themselves. And, if your portfolio fits a description that includes words like 60/40, Balanced, Target Date or Asset Allocation, the stock market may be but a piece of the current threat.
So, let’s help you to do a portfolio gut-check before these risks join, or even replace the stock market in the daily financial headlines. After all, many financial crises of the past 100 years had these hidden risks in common.
Lower-quality bonds: trouble on the horizon
If you review your holdings, be they individual securities or funds, you should be able to determine the level of “credit risk” in your portfolio. Specifically, if you own high-yield corporate bonds, high-yield muni bonds or preferred stocks, that’s a good indication that a hidden risk is about to identify itself. In fact, last week, that process started. A good example is companies in the oil sector, particular smaller ones that drill for oil. They flew higher during the U.S. shale oil boom. But they are highly-leveraged business. Now, the price of oil is down, companies owe money for the oil they already drilled or are in the process of drilling, and they are unlikely to be able to make ends meet. The debt markets have floated them the cash all this time, but the buck may literally stop here. That is one of many industries whose bonds just went from risky to severely damaged. This is one of the after-effects of the stock market bubble bursting, and the economy cratering as it is in the process of doing.
Here is what a breakdown in high-yield bond and preferred stock prices looked like in 2008, the last go-round for lower-quality bonds. Keep in mind that those declines include the income received from the bonds, and that this erosion of capital occurred in only about 6 months.
If you are a “long-term investor” in this part of your portfolio, just be aware that this type of pullback or worse could be possible, if current conditions in “junk debt” markets continue on their current course.
Do you understand what is in your “cash & equivalents” portfolio?
Does the chart below look like it tracks a pair of ETFs that could be described as “cash-like?” From my experience, they are often sold as such. I certainly hope that the money I would otherwise have in cash, money market funds, CDs and Treasury Bills would never be confused with this. Yet in every crisis, Senior Loan funds, Floating Rate funds and many other types are portrayed as some sort of free lunch for the investor.
I get it – in times of near-zero interest rates, investors want to reach for more. Their financial advisors should resist. But too often, they don’t. And then this happens. Will it recover? I suspect so, in time. Or not. But this is a lot more drama than most investors need.
This is why I am a huge fan of “long-short investing,” a topic I will cover separately this week. Rather than try to offset stock market risk with bonds and “cash” like you see above, I would rather try to identify opportunities to make money or limit losses in any environment. At a time where bonds are essentially a dead asset class for long-term investors, long-short, or hedged investing concepts are even more critical to understand. That is true whether you intend to practice it yourself, or offload that responsibility to someone else.
Can you lose money on Treasury Bonds? More than you could ever imagine!
When I saw these 2 charts, I feared I might have “buried the lead” on this story. Regardless, here it is. Over the past 15 years, US Treasury securities with “intermediate” maturities of 7-10 years have now about caught up with 60/40 portfolios. This screws up a lot of asset allocation software! But more importantly, it shows just how long-term overvalued the bond market is.
And, in the category of “higher risk” approaches to asset allocation, here is the S&P 500 ETF against 20-30 year U.S. Treasury Bonds during that same 15-year period. Despite the big move in stocks, “long bonds” have earned a strong portion of that return themselves.
Again, my conclusion is less about the stock market. I cover that in other articles this week. Instead, just think about what this means when interest rates rise and bonds fall in value.
I believe investors understand stock market volatility. That’s why there continues to be a lot talk about “buying the dip” and “finding a bottom.” However, investors don’t expect significant volatility from bonds and short-term funds. When those risks seem into the public consciousness, the emotional reaction will be many times worse than it was the past few weeks.
Your retirement, your choice
There has never been a better time to know what you own. Get underneath the hood of your portfolio, and identify uncommon sources of risk. I hope this article helped you to start that process.
Comments provided are informational only, not individual investment advice or recommendations. Sungarden provides Advisory Services through Dynamic Wealth Advisors.