In a special guest post, experienced advisor Sean Harrell gives his view on the role of fixed income investments in a modern portfolio.
The age old question: is investing in 100% fixed income actually riskier than investing in a diversified portfolio consisting of fixed income and a combination of equities, commodities and real estate? Well, in today’s market environment there are more things to consider than just diversification and asset allocation.
Modern Portfolio Theory was introduced by Harry Markowitz back in 1952. The basic principle behind his theory is that owning 100% of any one type of asset is riskier than diversifying your assets across multiple asset classes that have negative correlations. Then came along the ‘Efficient Frontier’, an asset allocation model that optimizes returns for a given amount of risk. The Efficient Frontier shows how adding a small portion of equity to a 100% fixed income portfolio actually decreases its risk and also illustrates how adding more equity to a portfolio increases both risk and potential returns.
These studies were created because many investors believed (and some still do) that investing in a 100% fixed income portfolio is safer than owning a diversified portfolio. Who can blame these investors? Typically, these investors are in their 50’s or 60’s and have experienced an incredible run in bonds while interest rates have been dropping for the past 40 years. Plus, some are still reeling from the financial crisis of 2008.
But today things are different. The past few years’ interest rates have stabilized at record lows and the only place for rates to go (long-term) is up. So, where does one invest if they still want a safe portfolio? Most advisors would argue that investing a healthy portion of your money in the safe fixed income asset class can actually bring on more risk than most investors realize.
We’re not referring to the typical investment risks like standard deviation, we are talking about interest rate risk and the risk of outliving your money. If (more like when) interest rates go up, it is virtually guaranteed that bonds will produce little to no return, or even worse, if you are holding long-term government bonds, you have the potential for negative returns. We are not saying that there is no place for fixed income in a portfolio, we are just asking the question, “how much of your money can you afford to earn zero return on?”
I believe that this brings about a new chapter in Markowitz’s theory and the Efficient Frontier. Advisors need to employ a new strategy that takes Markowitz’s work, the Efficient Frontier plus current market conditions into consideration. For me, it is a real concern that people will outlive their retirement assets if we as advisors don’t step up and educate investors about these risks.