Market Education

The world of investing is driven by two, seemingly competing, philosophies: - Indexers believe the financial markets are efficient and that effective investing means a responsible but passive approach. Stick your money in index funds and let them do the work. We tend to see many business leaders in high-growth companies fall into this camp. - Active Managers believe the markets are not always efficient, and that taking an active, diligent approach will result in higher gains because you can take advantage of market inefficiencies.

In our last post about impact investing, defined as institutional investing aimed at social and environmental good, we predicted the practice would continue to grow in the coming years, propelled in part by the increasing number of millennials who are becoming investors. As a generation, millennials tend to align their values with their investment decisions, a principle we encourage and discussed in our post about younger investors a few months ago. As of 2012, about $3.74 trillion of total assets under management were impact investments, according to a study we referred to our September post.

The saying “picking up nickels in front of a steamroller” is a good metaphor for what it’s like to buy bonds today.  June 2013 was especially painful for virtually all types of bonds and serves as a reminder for how fast they can fall.  While the sell-off was likely overdone near term, most bonds remain very expensive if one believes in regression to the mean.

Here’s the dilemma: nobody knows when the tide will turn.  What we do know is strategies that have worked well in the past, such as individual bond ladders, bond index funds, and typical “core” bond mutual funds, are all at high risk of earning less than inflation for years to come.  Despite these hurdles, investors can achieve positive real returns if they are willing to approach this asset class differently than they may have in the past.

Spend Risk Wisely

To be successful and preserve wealth, one has to take risks.  The key is spending your risk budget in a way that rewards risk taking rather than penalizes it.  With the combination of historically low rates and an improving economy, it’s time to invest defensively on maturity, offensively on credit, and capitalize on niche opportunities that still offer value.  Emphasizing active bond managers that are specialized, nimble, and proven is also critical to navigating these waters.  This approach is not expected to increase risk; rather, it optimizes the potential return by changing the composition of the risk.

Risks to Avoid / Reduce

Risks to Accept

Interest Rate Risk

Credit Risk

Purchasing Power Risk

Currency Risk

Reinvestment Risk

Credit Spread