Is it any wonder that the concept of the "conservative investor" is evolving? Inflation, higher interest rates and a red-hot stock market, heading towards correction, are creating a new breed of conservative investor.
"I remember the hyper-inflation of the early 80s," says Stuart Joseph, a broker friend of mine. "A bond selling at par, a $100 value, rapidly fell to $55."
Today's conservative investor needs to keep in mind that bonds, just like stocks, have risks. Know, in particular, that the longer it takes a bond to mature, the more susceptible it is to interest rate changes.
During a period of rising interest rates, I think it's important to consider:
Tweaking Asset Allocation -- Conservative investors need to decide for themselves if more stocks in asset allocation models
is the new normal or dangerously aggressive. Subtracting an individual's age from the number 100 is an old rule of thumb that financial professionals often use to allocate the percentage of stocks and bonds in a portfolio. A financially able 40-year-old might conceivably hold a portfolio of 60 percent stocks and 40 percent bonds. An affluent 75 year-old might hold 25 percent equities and 75 percent bonds.
Some leading mutual funds families, trying to fatten yields for their investors, are revising the 100 adage. These funds are now basically subtracting age from 112 or 120 to calculate stock percentages.
Conservative investors might be unaware that they're increasing their shares of equities by 40 percent or more of their previous asset allocation model. The 75 year-old, who thinks he's conservative, might now have a portfolio of 55 percent bonds and 45 percent stocks. With a dramatic stock market correction, this supposedly new portfolio might suffer larger losses.
Defending Bonds -- Bond duration, a method of measuring interest rate risk, helps predict how changes in interest rates affect bond prices. Investments with shorter maturities and durations are thought to reduce the impact of rising interest rates on bond prices.
Considering duration is important when investing in or monitoring bonds and bond mutual funds, calculate how much the price of a bond may increase or fall by multiplying duration by the change in interest rate. Should interest rates, for example, increase two percent for a 10 year treasury bond with an eight year duration, expect this bond's value to fall by about 16 percent. You're in for a rude awakening because a $1,000 bond would lose roughly $160, and now be worth about $840.
That's why many investors are considering short-term maturity bonds because they're thought to be more resilient if inflation increases. ETFs, exchange traded funds that follow indexes, are becoming more popular, too. Normalization of the economy might produce losses, though.
Managing Fixed Income Portfolios -- Savvy investors often build bond ladders, with staggered or different maturity dates, to reduce interest rate risk. Laddering may reduce the negative impact of holding Intermediate-term bonds, maturities of three to ten years, and long-term bonds, often held for 20 to 40 years. Shorter-term bonds, having maturities of less than three years, are thought to be less sensitive to interest rate hikes than longer term bonds.
Buying Dividend-Paying Stocks -- Many investors buy dividend paying blue-chip stocks, like GE or Exxon-Mobil, to reduce reliance on or complement fixed income investments. Stable dividend income, and, in good times, increases in stock price or dividends are perceived benefits.
Considering Floating Rate Bond Funds -- New floating rate investments come with interest rates that get periodically reset. The Federal funds rate or Libor plus a spread adjustment are used to adjust the investments interest rate. A floating rate note might, for instance, reset daily, monthly, quarterly or annually. Interest rates change, but the spread adjustment usually doesn't change. There are also mutual funds that invest in floating rate bonds.
When it comes to fixed-income investments, play it smart. Bear in mind that a bond bought at par, a $100 value, can still go down in value.
Jim Germer, a Bradenton CPA and a financial advisor with Cetera Financial Specialists LLC, my be contacted at (941) 746-5600 or firstname.lastname@example.org.