165: Asset Allocation in a Low Yield World

Learn why asset allocation models are broken, why and what to watch out for.

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Asset allocation is the backbone of investment firms. It's usually displayed by using pie charts with models of how much to invest in each slice to achieve a conservative, moderately conservative, moderate, moderately aggressive or aggressive mix of investments. The choices to put into the slices of the pie chart are things like small company stocks (roughly under $2 billion in market capitalization - price per share x number of shares), medium companies (mid-caps - $2 to $10 billion) and large companies ($10 billion+), International and bonds. The bonds can be divided into short-term (under 3 years), intermediate (3 to 10 years) or long-term (10+ years).

Sometimes a sector fund or two are also added like technology, healthcare or real estate. Real estate has become a staple in the last 15 years because it has been a top performing sector.

As I've mentioned on podcasts before, we are likely near a peak in bond prices because we are at low in yields, and yield and bond valuations move inversely. The coupon rate is the yield or interest rate the bond pays when issued. The higher interest rates move up, the lower the value of the bond goes. The lower the yield goes, the higher the value of the bond.

When you look at past-performance, the track records look phenomenal because yields have been dropping for over 30 years! That's one heck of a bull market for bonds. As interest rates dropped, the performance of the bonds was fantastic because again, they move inversely to interest rate movements.

Now that we're at the bottom for rates, what does that mean going forward?

A strong headwind for bonds. Bonds issued at low yields will lose value when interest rates rise and new bonds with higher yields become available.

Interest rates have to go up someday and usually move in 30 year cycles, so don't be fooled by investments that have a substantial portion of their money in bonds (like balanced funds which can be part stocks and part bonds, for example). The PAST looks great, but what will the future bring? Likely trouble for the bond portion of the fund. That's where looking only at past performance can hurt you. What happens when you sit down with most Financial Advisors? They show you great PAST PERFORMANCE numbers and encourage you to invest in a portfolio that has done well in the PAST. It has no relation to doing well going forward. In fact, in my podcast, Why NOT to Invest in 5 Star Funds, I proved that 5 star funds are actually worse performers going forward than 2 star funds.

The difficult thing is there's no risk-free asset that yields a decent yield anymore. You used to be able to get a few percent in a Treasury, but no more unless you go out years on the yield curve, meaning take more risk of volatility by moving into a longer maturing bond. A 20 year bond will fluctuate in value a lot more than a 3 year bond. So if interest rates rise and you have long-term bonds, you could lose substantial amounts of money.

So what can you do for asset allocation to avoid the low yields on bonds? You can mix in some other assets in place of bonds like large company stocks that pay dividends, REIT's, and other options. The purpose of this podcast isn't to explore all the alternatives, but to show you why past track records of bonds are tricky in asset allocation models and you need to be aware those great numbers of the last 30 years are not repeatable. Interest rates going from 18% in 1982 to roughly 0% today, means a dramatic decline in interest rates that boosted bonds cannot happen. The only thing we know is someday 0% rates will go up and that won't be positive for bonds. So be aware and don't be dazzled by past performance that's mathematically impossible to repeat going forward.