Fixed Income vs. Stocks
We most often use our own risk tolerance when deciding how much of our investments should be in stocks or fixed income, but just looking at this from this perspective is a mistake.
The problem arises when we approach these investments too generally, for instance using the assumption that stocks are riskier than bonds, and ignoring how current and forecasted conditions may alter this.
There isn’t much doubt that having investors ignoring both market and economic conditions benefits the investment industry, as paying attention to such things ends up in more turnover with investments. The risk to those selling investments is of course the one that involves your moving your money elsewhere, although we are done a disservice when we receive financial advice that may not be in our best interest.
The way they accomplish this is to have us believe that market fundamentals don’t really matter, that predicting trends by use of either fundamental or technical analysis is futile, in spite of evidence to the contrary.
So, we are not supposed to time our investments at all, because this is impossible to achieve, after all most mutual funds don’t beat the market, either ones in stocks or bonds. So, if these pros can’t beat the market by timing things, neither can you, and you are very well advised to refrain from this and just hold your investments indefinitely.
In reality though, both stocks and bonds are subject to clear trends which we can discern with a significantly higher probability than random. This is especially true with fixed income investments, where we can look at trends in interest rates, inflation, and other fundamentals and make some pretty good forecasts.
We can take this information, which is readily available and requires no real ability to interpret, and use it as a tool for deciding where our money should be invested. Institutional investors do this all the time, and go to great lengths to forecast markets, spending huge amounts on research, and in some cases these may be the same people that may tell you that this is a waste of time.
The stock and bond markets do not tend to move together all the time, and often times they move opposite each other. Economic growth for instance is good for the stock market but tends to be bad for bonds, because this results in higher inflation. Neither stocks nor bonds like interest rates going up that much, but stocks can go through some long bull runs when interest rates are higher, where bond markets get slammed during these times.
Higher interest rates can be a benefit in buying fixed income investments such as bonds if they are higher at the time purchase, especially if we expect them to go down. Seeing interest rates increase while you’re holding bonds though always means that their value goes down, and often goes down significantly, depending on the extent of the interest rate rise.
Looking At Where Each Market is Headed
The first question we should be asking ourselves when we consider what proportion of our investments should be in stocks or bonds should be where each market is headed over a given time frame.
While it is said that forecasted changes in financial markets are already priced in, this is only true to some degree and if you buy a stock for instance during a bear market, and the bear market continues as expected, you can count on its value going down, the same as what happens when you buy a bond during negative market conditions.
We can never predict these things with any great degree of certainty, but this does not mean that we cannot make predictions that are more likely than not to come true. Successful investing is always about managing probabilities, and staying in an investment when the probabilities are in your favor and exiting it when it is not is really the key.
There are two main movers of markets, which are supply and demand, and economic fundamentals. The stock market is influenced by fundamentals but really comes down to the amount of supply and demand for a stock or stocks in general. This is why, even long term, technical analysis performs significantly better than fundamental analysis with stocks, it comes down to how many people are buying and selling as far as price goes.
With fixed income investments, while supply and demand does exert its effect, the value of these investments are far more influenced by fundamentals, particularly interest rates. It is interest that they offer, so movements in interest rates will affect their value in an absolute fashion.
So, we always want to be looking at interest rate forecasts when we hold or are considering holding fixed income investments. While there may be situations where we may not care, if we’re planning on holding the investments to maturity, but just because we are able to do that does not mean that this is always the best approach.
If the market outlook for these investments are unfavorable, we may still be better off holding at least part of the money we have in fixed investments in another instrument, which includes both the stock market and in a savings class investment.
Fixed Income vs. Savings Vehicles
In some circumstances, it may be unwise to hold investments in either the stock or bond market, if the market outlook for both is poor. In this case, at least in terms of the choices we have between classes of securities goes, this leaves us with the savings class, by default.
If interest rates are going up and the stock market is doing poorly, in a bear market, savings vehicles such as certificates of deposit or short term treasuries, or even interest bearing savings accounts, may be the best choice for the time being.
There is a risk premium for all investments, and with fixed income securities, you are getting a better rate of return over savings accounts or instruments because there’s more risk involved with them.
There’s two components of this risk, the risk that the interest or coupon rate will become uncompetitive, and the risk that the investment itself may be worth less, both as a result of increasing interest rates.
With a savings account, you generally want interest rates to rise, although this must be tempered with rates of inflation, meaning that it is the net difference with inflation that really matters.
The same is true of fixed income investments though, so the difference comes down to savings investments having returns that move with the interest rate market, where most fixed income investments being fully exposed to this risk.
The longer a rate is fixed with an investment, the more interest rate risk one is exposed to, but one can purchase variable rate fixed income investments, or those that mature over a shorter term, to look to manage these risks.
This is why, within the category of fixed income investments, one is wise to focus more on variable rates as well as shorter terms should the risk of interest rates increasing become more significant.
Savings vehicles can accomplish the same thing though, and protect us against interest rate risk even more, even completely should we desire. Of course, the cost here is lower returns, but a lower return with the principal guaranteed can often be preferable than a return that both falls behind the market and results in significant capital losses at the same time.
In all cases though, it is important to always consider alternatives to our fixed income investments, even if we see ourselves as being fully committed to them. We should never be so committed to any investment that we refuse to even explore alternatives.