Market Conditions Really Matter Though in Deciding All This
The real key to proper asset allocation though is looking at the opportunity cost with an given type of investment, where we need to assess the desirability of one investment with another, based upon our expectation of the market.
If, for instance, the stock market is in decline, this of course wouldn’t be the best time to invest in the stock market, if you are going long that is, although it can be a great time to short the market. One need not short individual stocks to do this, as we can instead short indexes essentially by way of ETFs, or use other strategies such as rolling over short futures contracts in order to benefit from market declines while still achieving broad diversification.
Fixed income investments also have their bull and bear cycles, where the outlook may be positive or negative over a given period of time. In this case, it is the interest rate market that determines this outlook, where if interest rates are expected to be stable, declining, or increasing, this should affect our decision making as to what to allocate to fixed income investments.
We will first have to decide whether or not we will choose to allocate more or less to the fixed income portion of our portfolio, and if interest rates are expected to increase, we may want to seriously consider whether we should add to our position with fixed income investments, or even look to move some or all of these investments into some other form, one with a more positive outlook over our chosen time frame.
Perhaps the stock market is moving in the other direction and conditions are more bullish, where if we expect interest rates to rise, we may want to sell some of our bonds or preferred shares and invest in stocks or a stock index instead.
Perhaps both the stock market and bond market may be bearish at the same time though, in which case we may want to place more of our portfolio in savings vehicles, to wait out the storm so to speak, or to take other strategies designed to minimize our risk exposure to interest rates.
Many investors have the attitude that since you can’t predict future market conditions with any real certainty, we should not look to time our asset allocation at all. While it is certainly easier to ignore market conditions and just select a certain strategy and stick with it, we quite often have a pretty good idea about where markets are headed. This is especially true with interest rates, at least as far as having a broad idea of what type of market we may expect with them, as in increasing, declining, or being in a fairly flat interest rate environment.
Looking At Interest Rate Expectations
One of the real benefits of forecasting interest rates is that it is like a big ship, it takes a lot of time to turn around and will do so in a fairly predictable manner. The same is true of the stock market to a degree but certainly a lesser one.
We can also get a notion of the degree of change as well, by looking at the recent past as well as our forecasting. In 2017, for instance, we know that interest rates have been rising slightly over the near term and it’s been quite a while since we’ve had to worry about declining interest rates, as this hasn’t been the case for about a decade at this point.
The value of fixed income investments moves in the opposite direction of interest rates, and the risk is that interest rates will increase significantly, and the value of our fixed income investments will decline as a result.
If you bought an investment that returned 3% today, and in a couple of years the same investment paid 5%, your investment will be worth quite a bit less if you sold it. Even if you did not sell, with inflation rising along with interest rates as it usually does, the increased inflation that comes with this would make your income stream lose value as well.
Therefore, where interest rates are headed should influence our decisions about allocation to fixed income, and more than it typically does in fact. Advisors will prescribe different strategies in increasing or declining interest rate environments, but these strategies tend to focus more on either proportioning different time frames of types of fixed income investments rather than suggesting people move in and out of them in general more.
This doesn’t mean that the advice we get is always lacking, but we focus too much on demographics and other characteristics particular to each investor rather than market outlook when looking to decide such things. If the expectation is that a particular asset class will decline significantly over the near term, even if we’re looking to invest beyond that, we can always change horses later, but we should pay attention to which horse we should be on at any given time.
Markets in general will move money from one asset class to another quite regularly, especially the so called smart money, and this does influence markets pretty significantly at times. This is the biggest reason behind bear markets in the stock market for instance, money is moving out of the stock market and into other types of investments, reducing both demand and price for stocks.
It can be wise to look to do this ourselves at times, as the market conditions may dictate, and this is the case with fixed income investments in particular. We may not want to move money from bonds to stocks due to not wishing to be exposed to their additional risk, but we may want to consider moving some of our money to a savings type investment, or even hold it in a savings account, one in which the interest rate is variable, as well as allowing these conditions to alter our strategies within our fixed income portion of our portfolio.
Strategic Management of our Fixed Income Portfolio
Aside from allocating a portion of our fixed income portfolio to another asset class, there are some rules of thumb that apply to interest rate environments that may either cause us to seek out certain strategies to manage interest rate risk more effectively, as well as tactics that allow us to manage it better when conditions do change.
The laddering strategy is one that is used with both fixed income investments as well as fixed period savings investments such as CDs. It involves staggering the maturity of these investments, where a certain percentage of our investments will renew at a point in time, each year or every few years, which allows us to better adapt to changing interest rate conditions.
With bonds, there is a similar strategy called the barbell where one holds both long and shorter term bonds, foregoing medium term ones, and this can have the benefit of having more of our investments longer term than with a ladder, while also being able to adapt better to changing conditions with a larger percentage of our holdings in shorter term bonds.
When interest rates are low, and business conditions are positive, we may also want to look to take advantage more of the higher yields that preferred shares in some of the better companies provide, as an alternative to bonds. Preferred shares can certainly have their place at such times.
If we expect that interest rates will increase, should we decide to keep some or all of our investments in fixed income, we will want to focus on both shorter-term investments as well as those based upon a floating rate. This will at least offset some of the risk involved in these markets with fixed income investments, as it allows the value of our investments to move with the market rather than be subject to the full devaluation that occurs here otherwise.
If interest rates are expected to decline, we will then want to go with fixed rates, as fixed rate investments will increase in value during these times, while floating rate investments will decline in value with the market.
Overall, there are a number of different strategies that we can take with the fixed income segment of our portfolios. This may start with what seems reasonable according to our goals and risk tolerances, but also should take market conditions into account, and market conditions can be an even bigger deal in certain environments.