Investing in a Risky World with Low, Low Interest Rates
The environment for investing today is as challenging as it has ever been.
- · On the one hand, we have experienced a series of “100 Year Flood” type events, including the inflation and bursting of the tech bubble, 9/11 and the near meltdown of the financial system, which is still reverberating around the world. Our economy is so challenged that the central bank has pledged to keep interest rates at zero for years. There is a resulting inclination to take some cover; to reduce portfolio risk in return for a “safer” albeit lower portfolio return.
- · On the other hand, fixed income investments, which have historically provided less volatility than stocks, now offer very little in the way of yield. Total return on bonds has been very good over an extended period of time due to the persistent downward thrust of interest rates. And it is possible that there is a little fuel left in that tank, as some have called for rates on 10 Year Treasury bonds to decline as low as 1% from 1.75% currently (which would produce a 7% increase in price).
The scenario for 10 year bonds at 1% would not be a good one and it is not one we think is likely to come to pass. Given that, investors are caught in a bind that both demands some credible portfolio return in order to fund future needs, preserve purchasing power or support/enhance a lifestyle or mission and blunts the risk of a major drawdown of capital, as experienced in a “100 Year Flood” event.
Our friends at Fund Evaluation Group put together a presentation entitled “Balancing Market Risk and Shortfall Risk”. While published about a year ago, it remains a timely piece which helps guide investors in their risk management process. Risk can be managed by:
- · Avoiding Risk
When high quality bond yields are “normal”, investors can forego riskier asset classes and still achieve some return. At today’s yields, your market risk is largely offset by shortfall risk.
- · Hedging Risk
Hedging with derivative instruments can reduce risk but there are costs to hedging. In today’s environment, those costs are high.
- · Diversification
Diversification among asset classes that have low correlation to one another has been a time tested means of risk management. Lately, however, the “risk on-risk off” world that we live in has played havoc with this route as all asset classes except Treasury Bonds go down together (high correlation).
- · Active Risk Management
Finally, active risk management is an approach that may be new to some investors. It involves using risk avoidance, hedging and diversification at the portfolio level on an opportunistic basis. Not to be confused with market timing, active risk management involves tactical asset allocation to complement and enhance long term strategic allocation.