Why We Invest as if We Don’t Know

If you heard me talk about markets, it’s inevitable that you’ve heard me say things I believe to be true. First, I assume I don’t know what’s going to happen because I don’t. And second, we take that saying and apply it to our client portfolios. What does that even mean?

The media is full of highly credentialed talking heads making predictions about where markets are headed next. Often, there will be two opposing viewpoints with the credibility to back each claim. But in my experience, I have yet to run into someone who can reliably predict the future. Most pundits fail to even be half right with their predictions. As a finance nerd, these are people who I idolize. They’ve obviously done the research and leaned on a wealth of experience to come to whatever conclusion they came up with, but they’re wrong. 

It doesn’t mean we shouldn’t listen to experts. Just do so with a skeptical ear. Predictions aren’t completely useless because readers can still gain some insight, and perspective is valuable. I also give them credit because I don’t make bold predictions. It’s nearly the opposite when we approach a portfolio for our clients. Diversifying holdings is the best way to hedge in case predictions go wrong. Our investment thesis to start the year does have a forward-looking outlook, but nowhere in our prediction was Russia/Ukraine. Putin’s war brought several surprises and increased uncertainty. We have not changed our portfolios because we headed into the year with a well-diversified plan. 

Our focus from the start of the year still remains, which is interest rates and inflation. Several predictions turned out right but some were wrong. But we did not change course because we had proper diversification in place. 

US treasuries are one of the most difficult asset classes to own in 2022. Bonds aren’t supposed to go down, right? As of April 26, 2022, the Fed has only raised rates by 0.25% but the bond market has already priced in higher rates. When rates go up, bonds of different maturities tend to go down. The overall bond market is down about 7.5% this year, the worst start in 40 years. The chart below is showing year to date returns through April 26, 2022, for three varieties of bonds which are all US treasuries. First is short duration, which are bonds maturing within 3 years. Second is intermediate duration, which are bonds maturing in 7-10 years. Lastly, are long duration, which are 20+ year maturities.

A bond investor is essentially a lender to the US government (treasuries), to corporations (corporate bonds), and to cities and states (municipal bonds). (There are many more bond types but we’ll keep it to the three big ones for simplicity.) As a lender, you want interest on the amount of money you loan out. Say you bought a US treasury bond. What that really means is you are loaning money to the US government in exchange for interest and your principal down the line. 

So, why do bond prices fall when interest rates rise? 

Let’s say that the interest rate you’re getting is 1% in 2020. A $100 loan will get you $1 per year in interest and that $100 back in say 10 years. 

Now, fast forward to 2022 and rates are up to 3%. Would you rather own a bond paying 1% or 3%? The bond you bought is paying 1% but market rates are pricing 3% interest on new bonds. The bond you’re holding doesn’t look as attractive! When rates go up, prices of bonds go down because the market can get new bonds at higher rates. The effect is magnified with longer-dated bonds. 

Does that make the old bonds useless? No, the price goes down on that $100 bond to make up the difference in yield. So, anyone buying that bond before maturity would buy it at a discount. Below is an illustration of this occurrence from Fidelity.

Bond prices will move up as rates go down. What may cause rates to go down? In 2020, when we locked down the global economy, interest rates essentially went to zero. Typically, when the stock market is selling off, those proceeds tend to go the bond market. Demand for safety tends to push rates down.

This is a chart with the same US treasuries but during the selloff in 2020 between February 10th and March 23rd. The new addition is the S&P500 where we experienced a 33% sell-off. Much of that money went into US treasuries as investors rushed to safety. 

A not-so-brutal selloff occurred on Christmas eve 2018. Again, US treasuries provided some buffers in well-diversified portfolios.

There’s no guarantee that US treasuries will provide this level of support going forward, but they do have a history of being the safe haven that global investors look for in bad times. The US government has never defaulted on its debt. Again, no guarantee but still an impressive track record. Some investors prefer gold as that safe haven, but the problem is, gold doesn’t pay any interest and it costs money to store the actual metal. The key to a diversified portfolio is to hold some of these assets in good times, and in case of bad times. Anyone who bought treasuries after a crash was typically too late. Rates go up when the economy and markets recover. Remember, when rates go up, bond prices tend to go down. 

We hold treasuries in combination with our mutual funds and ETF holdings. Treasuries have recently been a source of volatility. In its fight with inflation, the Fed has stated it will raise interest rates to cool the economy and the bond market has already attempted to price that in. This has two effects on bonds. First, the prices of bonds have gone down YTD. Second, the yields on bonds have gone up significantly. 

I have professionally experienced the events in both charts above (and countless more will come!). And, the portfolios we manage hold a portion in US treasury bonds. There will be a day where we’ll need them to help limit downside. Do I know when? No. That’s why I invest as if I don’t know. Because I don’t. 

Disclosures

The information provided is for educational and informational purposes only and does not constitute investment advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell a security. It does not take into account any investor's particular investment objectives, strategies, tax status or investment horizon. You should consult your attorney or tax advisor.

The views expressed in this commentary are subject to change based on market and other conditions. These documents may contain certain statements that may be deemed forward‐looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Any projections, market outlooks, or estimates are based upon certain assumptions and should not be construed as indicative of actual events that will occur.