By Tim Courtney, Chief Investment Officer
The market doesn’t move in a straight line, but over the past 20 years save a few bumps here and there, investors have gotten used to falling interest rates and falling inflation. Lower interest rates typically support higher stock and bond valuations, while falling inflation enhanced the value of future earnings and interest.1 Combined, these factors created a greenhouse for investors – an environment just right for many financial assets such as stocks and bonds. However, rising interest rates and inflation have forced assets to grow on their own without the benefit of a perfect environment, and this year both stocks and bonds are down.
For decades, a portfolio focused on holding a combination of stocks and bonds has been the standard for investors. A portfolio composed of 60% stocks and 40% bonds has been considered the traditional allocation for a “balanced” investor. Historically, it has had a reasonable risk/return profile, however, some are questioning this strategy now that interest rates are negatively affecting both stocks and bonds. As such, we revisit the rationale for holding these assets in a portfolio below.
Since stock prices are more volatile and tend to have multiple 20% or greater declines over the course of a decade, if all things were equal, investors might prefer to hold bonds, with more muted price movements and where declines over 10% are rare. But all things are not equal.
Most bonds produce coupon payments that are fixed whereas stocks give investors access to a potentially growing stream of profits. Profit growth for the S&P 500 Index has averaged close to 6% a year over the last century (7.8% over the last 20 years).2 Compounded over time, that has provided stock investors with purchasing power growth after inflation and taxes. Most of us either need or want our real purchasing power to grow in order to retire, provide for our heirs and make gifts to charity.
Bonds likely won’t be able to provide an investor with meaningful purchasing power growth after inflation and taxes. There have been instances where bonds did so, however. In 1981 you could have purchased a treasury paying 15% interest every year for 30 years.3 That said, we generally don’t hold bonds to grow our real purchasing power over time. We hold bonds and other similar assets to help smooth out the overall portfolio’s volatility and behavior. More importantly, when an investor needs to sell an asset to provide for spending needs, bonds can often be sold at a relatively good price during most stock declines when prices for stock sellers are unattractive.
This year so far has been rough for financial assets as markets readjust to higher rates. Stocks have fallen between 10-20%4 and intermediate to long-term bonds are down more than 10%,5 while shorter-term bonds are down much less and make up a meaningful amount of our bond exposure. We believe these assets remain the primary tools to utilize in most cases, but it can make sense to have exposure to other assets and strategies. If you have any questions about the assets within your portfolio, please contact your Exencial advisor.
Sources:
- Investopedia (6/25/22) — How do interest rates affect the stock market?
- SPGlobal.com (07/31/22) — S&P 500 Index earnings and estimate report
- Macro Trends — 30 Year Treasury rate – 39 year historical chart
- CNBC (7/13/22) — S&P 500 tumbles nearly 4% to new low for the year, closes in bear market territory
- Yahoo! Finance (8/25/22) — US Treasury bonds rates
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