Taking Stock

Happy New Year! May your 2014 be healthy and prosperous in all respects, including financially.

I hope 2013 was everything you wished for as well.  From an investment standpoint, to the degree that you held US stocks and US stock funds, you should have much to be thankful for.   Your bond holdings on the other hand, probably went the other way.  That is ok, in fact that is the whole point of diversifying your portfolio.  Some investments should go up while others go down and then, hopefully, vice versa.

In 2013 it was US Stocks’ turn to go up.  That’s a good thing, but you can definitely have too much of a good thing (Christmas cookies and egg nog come to mind).  So, if you are making plans to trim your waistline, you may want to pare your exposure to stocks back to your planned allocation as well.

What’s that…you don’t have a financial plan with a target allocation based on your needs and risk tolerance?  Well you should make a resolution to find an advisor to help you determine what your personal allocation to stocks, cash and bonds should be.

If you, have already done that, congratulations!  But, your financial plan isn’t a onetime document to put in a drawer, it is part of a process that should continually be reviewed and revised or at least refined.  What better time than New Years?  Assuming your planned allocations still look appropriate for your circumstances, you may now have a larger proportion stocks than you intended.  Your plan should tell you to rebalance by selling some “riskier” stocks and buying more “safer” fixed income investments.  But, which fixed income investments are safer?

Stocks Are (Always) Risky But Some Bonds May Be Riskier In A Rising Interest Rate Environment.  Short term volatility is often used to describe risk in investing. The real measure of risk is not just how far down an investment may fall, but how far and for how long.  Bond bear markets, which are tied to interest rate cycles, can last even longer than stock bear markets.  With that in mind, selling longer term bond funds, junk bond funds and even some of your investment grade intermediate term  bond funds can reduce the downside of an eventual rise in interest rates that could be a long time coming, but is almost guaranteed.  Longer-term and lower quality (junk) bond funds, are most susceptible to bond market losses. But even an intermediate term fund with only a five year average maturity could lose nearly 10% in value if interest rates rise 2%.

Short term bond funds are less vulnerable.  The trade-off from moving to shorter term bonds means the fixed income portion of your portfolio, which includes cash and bonds or bond funds, may have less risk of loss of principal, but more risk from inflation and less upside potential from yield or appreciation. Since I recommend taking a Total Return approach to investing that emphasizes the stability that Fixed Income investments add to a portfolio over the specific amount of income they generate (after all, qualified dividends and long term capital gains from stocks often yield better after tax income than bonds). So, for the time being, I don’t think we have much choice but to accept the lower rates that short term fixed income investments offer.

Maintain Your Discipline.  At the same time the Fed is limiting our ability to earn a reasonable interest rate, they are artificially inflating stock prices (which could also go on for a long time). So I recommend maintaining whatever long-term ratio of stocks to fixed income (including cash) you and your advisor have selected, rather than trying to time the market by temporarily or “tactically” increasing the percentage of stocks. If stock prices keep rising, you should periodically rebalance to maintain that mix by selling stock funds and buying more of those frustratingly, low yield, fixed income investments.  That is hard to stomach, but when stocks and bonds move the other way it can be even harder to buy stocks after watching them drop.  After all, real discipline is not just riding out a downturn, but buying what is on sale in the middle of the downturn.  It is easier said than done, but consistency in asset allocation is arguably more important for long term success than a specific asset allocation.

Take What You Can Get.  The old adage that you can’t fight the Fed is as true today as it ever was and the Fed is currently punishing savers.  Unfortunately, we have no choice but to take it.  Assuming more risk in fixed income by going longer term or lesser quality is generally not as rewarding as taking on risk in stocks, which as I mentioned previously, should be a consistent (strategic) proportion of your investment portfolio.  So, we can only hope our fixed income (short and intermediate term investment grade bonds) investments provide some stability (by counterbalancing our stock funds) and enough liquidity that we can roll into higher yielding investments as they become available.  But, for now, we have to accept that they will yield very little.  In fact, some investors may want to reduce that fixed income yield even more by hedging their intermediate bond funds with short term (more closely matched to intermediate bonds) Treasury Inflation Protected Securities (TIPS), which will only pay off if inflation (not interest rates) rise more than expected.  Consult your financial advisor to determine if this may be a good strategy for you.

Make The Most Of It.  If you move to shorter duration and higher quality bond funds, your fixed income portfolio will look more and more cash like.  With rates so low, it can be easy to be complacent and miss opportunities to keep your money working for you by letting it ride in money market accounts or savings accounts with average yields.  That may be fine for shorter term emergency funds or working capital, but there are some other options worth considering.

Shop For The Best Rates.  You don’t have to live with whatever savings rates your local bank offers.  The internet makes it possible to move your money almost anywhere in the country. You can find some of the most competitive current (they change often) rates for: Savings Accounts, Checking Accounts, Money Markets and CDs at BankRate.com   and  DepositAccounts.com .

Consider Longer Term CDs For Shorter Terms.  Some longer term CDs have low enough early withdrawal penalties that you might want to consider them for funds that you hope to roll into higher yielding investments in the short term.  For example (not a recommendation), Ally Bank offers a high yielding FDIC  insured 5 year CD that has relatively small penalties for early withdrawal.  Those penalties went up on Dec. 7th, but as Allan Roth explains,  it is still attractive even if you only stay in for six months.  As with any investment, there are drawbacks.  For instance, you have to pay attention to maturity dates, or your funds will be automatically rolled into a new CD.   Also according to the fine print, there may also be a delay or restriction in getting your early withdrawal, which I assume protects the bank from a run.  But the CD is an FDIC insured deposit product, so the risk is to liquidity, not principal or interest should the bank fail, if you don’t exceed the $250,000 FDIC limit.  Although the liquidity risk might be slight, if you might need the funds quickly, this is probably not a good place to park your money.

In another example (again, not a recommendation), Alan Roth found an NCUA  insured three year CD from Pentagon Federal Credit Union which is being offered for an unspecified “limited time”, and which if held for 21 months or more would pay more than the Ally Bank 5 year CD. You can read about it at Where you Can Stash Your Cash This Fall   (Note that all credit unions have membership requirements, and only Pentagon Federal Credit Union members can open an account there).

As Ken Tumin points out, this strategy is not without risks. So you should definitely do your own homework, including reading the fine print and discussing it with your financial advisor, to determine if it makes sense for you.  But it might be worth the effort.

Another Kind of Inflation Protection.  Finally, while you can’t fight the Fed, you can invest in the US Treasury.  By opening a Treasury Direct account, an investor can purchase up to $10,000 of I-Bonds each year.  So together, a couple can invest $20,000 in 2014.  In addition, if you overpaid estimated taxes last year you can get up to $5000 of paper I-Bonds as a tax refund next April.

Although you can’t redeem them for at least a year and will pay a penalty of three month’s interest if you redeem them in less than five years, I like I-Bonds more than Treasury Inflation Protected Securities (TIPS) as an inflation hedge.  I-Bonds pay a combination of a stated (at issue) interest rate and a floating interest rate equal to inflation that is adjusted every six months. Interest, which accrues and is compounded in the bond, is tax deferred (unless you choose to report it annually) and the principal and the fixed rate portion of the interest is guaranteed.  The combined rate can’t go below 0%, so you are protected against deflation.  TIPS, on the other hand, can have a negative real return (actual return minus inflation) because the principal is adjusted for inflation. There is also no tax deferral with TIPS since they pay out federally taxable interest continually.  After one year, you can redeem an unlimited amount of I Bonds, but if interest rates rise and you want to roll your redemptions into current I-Bonds with higher fixed rates, you are limited to $10,000 per investor each year.