By now, you've probably heard over and over again that the "secret" to a successful investment portfolio is diversification.
Most people take this to mean buying bonds for stability and stocks for a better return. They might do small-, mid- and large-cap stocks or vary the duration of their bonds. But for a lot of people, that’s as far as they’re willing to take their mix.
Now, because of the Fed’s efforts to stimulate the economy — cutting the federal funds rate from about 5.25% to nearly zero and implementing quantitative easing programs to increase the money supply — that might not be enough. The government’s efforts to turn things around after the 2008 financial crisis may have put the two most popular asset classes on shaky ground. Here’s how:
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The Effect of Easy Money
When the central banking system made it easier for companies to borrow money at a very low cost, it allowed them to put cash back into their businesses and improve their profitability. Companies began expanding or, at least, shedding debt, which had a positive effect on stock prices. And consumers — who weren’t getting a good yield from more conservative investments — took notice.
At the same time, the drop in interest rates pushed bond prices up, because potential buyers could get more interest on existing bonds than on those that were newly issued. Yield was down, but values went up, and again consumers had a positive reaction.
A Potentially Dangerous Correlation
Historically, if there has been any correlation between stocks and bonds, it was negative. If one did well, the other did not, and consumers viewed them as solid hedges against each other. But for the past eight years, because of the Fed’s intervention, their values have risen simultaneously.
On March 15 the Fed announced it was raising its key interest by 0.25% to a target range between 0.75% and 1%. It was just the third time it has raised rates since the financial crisis. And so, as we find ourselves at the tail end of this long-imposed low-interest environment, it’s difficult to predict how the markets will react. But chances are it won’t be pretty.
There’s an old saying that when interest rates rise, stocks will die. Investors who were willing to take a risk when they could get only 2% interest on their bonds or CDs likely will go back to those more conservative investments once the yields increase.
In the same vein, because bond values have increased so much over the last eight years, as interest rates start to go up, the value of most current bond assets probably will go down.
Steps Investors Can Take
What should a wise individual consider to prepare for a possible double-bubble situation?
- Diversify. It’s still a good policy — just remember that diversification can be so much more than stocks and bonds. It can be commodities, international exposure, emerging market exposure, annuities, real estate and more. Consider additions that might benefit from rising inflation.
- Look into the possibilities of tactical vs. strategic asset management. A tactical wealth manager will take a more proactive approach, changing positions and allocations with your financial vehicles as the market dictates. Often your gains will be smaller, but so will your losses. And if you’re close to retirement or averse to risk, this may be a consideration for you.
- If you choose to stick with a strategic management style, consider your time horizon, make forward-looking decisions and then stay with them. Don’t panic! If you aren’t currently working with a financial professional, now is the time to start looking for someone you can trust. Don’t settle. Find someone who understands your risk tolerance and will communicate with you through good times and bad.
Kim Franke-Folstad contributed to this article.
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