Low interest rates test investor discipline

The Federal Reserve has been engaged in aggressive monetary easing ever since the financial crisis began. First, the central bank rapidly lowered short-term interest rates to nearly zero. When that didn't get the economy moving, it expanded the types of acceptable collateral for making loans to the financial system. Then the Fed essentially tripled its balance sheet, buying bonds of various types and maturities (basically becoming a big hedge fund). The latest move to shock the economy back to life, "Operation Twist," was designed to try and lower longer-term rates.

While these efforts may have been effective in helping the economic recovery, they've had a negative effect on savers, especially senior citizens who often depend on the cash flows from their investment portfolios. Almost daily I hear from investors that they "need more yield."

When I hear that lament, my response is, "So you are telling me you need more risk in your portfolio." They repeat, "No, I need more yield." And I repeat my statement until they figure out that the two statements are synonymous. About the only free lunch in investing is diversification. If you want more yield, you have to be willing to accept the greater risks implied by the higher yield.

Learning from disaster

Unfortunately, the same people who say they need more yield are typically those who don't have the ability, let alone the tolerance, to accept more risk. Still, I'm finding that normally conservative investors are considering taking on significantly greater risk than they should. They're succumbing to the temptation to ramp up risk either in the form of dividend-paying stocks, high-yield (junk) bonds, preferred stocks, real estate investment trusts, master limited partnerships, and even emerging-market bonds.

What is surprising is just how short these investors' memories are. It was only four years ago, in the thick of the financial crisis, that investors were taught the lesson that only the highest quality fixed income investments (such as Treasuries, FDIC-insured CDs and AAA/AA-rated municipal bonds) provided a haven from the storm that hit  stocks and riskier bond investments alike. So, just when you need the bond portion of your portfolio to offer protection, instead it drags you deeper into the quagmire.

During the bear market of 2008, while dividend-paying stocks may have provided a yield of perhaps 4 or 5 percent, they also may have lost 50 percent or more in value. Many slashed, or even eliminated, their dividends. REITs fell almost 40 percent. And junk bonds, preferred stocks, and emerging-market bonds all suffered huge losses.

One of the cardinal rules of prudent investing is that the role of the fixed-income portion of your portfolio is to reduce the overall risk to an acceptable level. That means only the safest fixed-income investments should be considered. Remember, it takes a lot of interest to make up for unpaid principal.

Where to take risks

If you want or need more risk in your portfolio, the appropriate place to take that risk is in stocks, not bonds. One reason is that you can diversify the risks more effectively with stocks. A globally diversified portfolio using passively managed funds could easily contain more than 10,000 stocks. Another reason is that the risk premiums are earned in a tax-efficient manner, mostly at long-term capital-gain rates. On the other hand, bond risk premiums are typically earned in a tax-inefficient manner, with the premium coming in the form of higher interest rates and that income being taxed at higher, ordinary income tax rates.

If you ignore my advice and decide to purchase risky bond investments, your plan should recognize that incremental risk. For example, a high-yield bond fund (such as the Vanguard High-Yield Corporate Fund (VWEHX)) shouldn't be considered as a 100 percent allocation to fixed income. Instead, it should be considered as 25 percent stocks and 75 percent bonds. And a junk-bond fund should be considered a 50/50 allocation.

Every so often, the market tests investor discipline. Only in 2003, for instance, the Fed engaged in a similar policy of monetary easing (and look what that led to). In an effort to fight the recession that followed the dot-com crash in 2000, the central bank drove rates way down, though not to zero as they have during the latest crisis. In June 2003, the interest rate on one-year Treasury note fell to less than 1 percent. And investors began to stretch for yield. Those investors who took on significant credit risk in a search of yield likely paid a steep price for that higher yield when the financial crisis hit in 2007 -- demonstrating that higher yield and higher return aren't synonymous.

One of the most important roles for a good financial adviser is to design the right asset-allocation strategy and then make sure that discipline is maintained. That means avoiding undue risk. If an investor needs more cash flow than they can get from the safest investments, the role of a trusted adviser is to seek out other alternatives that don't entail significant incremental risks. One possible solution is a payout annuity, which benefits from the mortality credits embedded in the contract. Even a reverse-mortgage might be appropriate, while an alternative would be to adjust spending patterns. If none of these options are appropriate, the risks should instead be taken on the stock side of the portfolio. 

This, too, shall pass

Finally, just as the period of exceptionally low rates that we experienced in 2003 passed, the current low rates we're seeing now also won't last forever. The reason is simple. Over the long term, the U.S. economy has grown at a real rate of about 3 percent. Current interest rates are inconsistent with that level of real economic growth (or anything close to it).

Since 1964, the real rate on one-month Treasury bills has average about 1 percent, the rate on one-year Treasuries about 2 percent, and the rate on intermediate and longer-term Treasuries about 3 percent. If we go back to 1926, the real rates drop to about 0.6 percent on one-month bills, 2.3 percent on five-year notes, and 2.5 percent on long-term bonds. Given that the current expectation for inflation is about 2.5 percent, investors likely won't have to wait too much longer for rates to start to rise to more "normal" levels, perhaps in the 4-5 percent range.

In the meantime, investors will likely need all the patience and discipline they can muster. Hopefully, you will pass the test. Many who failed the test in 2003 learned a harsh -- but instructive -- lesson: There are some failures you never recover from.