Eric J. Freedman
CAPTRUST Chief Investment Officer
“Most of us have two lives. The life we live, and the unlived life within us. Between the two is Resistance.” (Steven Pressfield)[i]
Decisions. Life is full of them. Small ones like what’s for lunch, and big ones like marriage or vocation. Some decisions must be made immediately, while others lend themselves to delays. Steven Pressfield provides the quote under this piece’s title from his book about overcoming procrastination. Indecision can act as a wedge between what we want to do and what we actually complete.
When I debate what to pen each quarter, several potential topics invariably emerge. This time is no different. Current events offer several worthy avenues for exploration. Yet, the most important investment strategy issue right now is not when the U.S. Federal Reserve will raise interest rates, the Chinese stock market, or the Greek debt drama.
The most critical issue right now is the question every investor needs to ask: Do I take on more portfolio risk in an attempt to achieve higher returns, or am I content accepting likely lower returns given the current investment backdrop? This is not a new concept but, in my view, it is one that is too often ignored by financial intermediaries and the clients they serve.
CAPTRUST, along with many of its industry colleagues, forecast lower expected returns than investors have experienced in the past. This is largely a function of low interest rates (and high bond prices) and lofty valuations for equities. Aggressive pro-growth central bank activities have fueled this phenomenon. One consistent central bank tactic has been to buy government bonds to help restrain business and consumer borrowing costs. This push to buy bonds has helped the latest rally in what has been a 34-year bull market for the fixed income asset class.
Bond prices, particularly government bond prices from major economies, serve as a starting point for other asset prices, including stocks, real estate, currencies, and commodities. Although recent bond market movements in Switzerland, Germany, Denmark, and other regions show that negative interest rates (this happens when investors buy debt securities at prices that exceed their future cash flows) can occur, the closer interest rates move to zero, the lower returns investors should expect from bond, and by implication other asset classes.
Bonds may be challenged in coming years as major central banks like the U.S. Federal Reserve and Bank of England begin to move off their pro-growth policies, fearing inflationary risks as economies recover. Yet, as tempting as it may be to abandon bonds, they can still serve a key portfolio role. During periods of heightened uncertainty that result in a flight to safety, bonds tend to perform well. For example, during the recent Greek malaise, fixed income securities, particularly U.S. Treasurys, rose while riskier asset classes fell. To further complicate matters, bonds gave up a lot of their gains after the initial Greek shock. The investor’s dilemma is captured in that tradeoff.
Should investors maintain a more traditional asset allocation: for example, a 60 percent stock/40 percent bond portfolio, with bonds serving as a proverbial anchor windward? Or should investors adopt a different approach? Investors have not had to veer from this orientation in recent history. Stocks, despite a few stumbles, have compensated patient investors willing to stay the course. Bonds have delivered consistent returns, thanks to stable inflation in most developed economies since the early 1980s. More recently, they have benefited from central bank actions. But will these tools, and the proportions investors allocate to them, need to change to fund what investors have invested in them for in the first place? We think the answer is yes. Investors must either take on more portfolio risk or accept lower returns. But we suspect too few investors are actively answering that question.
From an investment perspective, behavioral finance is teeming with studies about indecision. As Harvard and Yale economists highlight in a 2006 study, “financial decisions, such as choosing a savings rate or asset allocation, are often complicated. One potential consequence of this complexity is that individuals put off confronting these difficult decisions.”[ii] Investment product proliferation, coupled with the media that have replaced thorough analysis with sound bites, has likely increased investor indecision.
One standard economic model evaluating how individuals make decisions is called rational choice, which economists Jonathan Levin and Paul Milgrom define as “the process of determining what options are available and then choosing the most preferred one according to some consistent criterion.”[iii]
One of the most basic and scarce resources people must allocate is their money. Consistent with the rational choice concept, to do this they must know what their options are. In an investment context, these choices are asset classes like stocks and bonds. Investors also need to know how to assess their options and understand the process through which they will select asset classes to build a portfolio.
Ultimately, portfolios are objective-based; people invest to achieve some aim such as beating inflation, paying for their kids’ college education, or meeting a targeted return if they represent a pension or endowment.
The Model in Action
For someone outside of the financial industry, understanding available options and how to evaluate them is extremely challenging. Managing this complexity for investors is what keeps companies like CAPTRUST in business. Our job is to use capital market tools to help individual investors and institutions achieve their goals.
Our view of bonds is that they are unlikely to deliver the same kind of returns they have in the past. Fixed income has been one of the most consistent return sources, averaging an 8.5 percent total return per year with 67 percent less volatility than stocks since interest rates peaked in September 1981. Returns like that can only be achieved if we see firmly negative interest rates. Because my work focuses on probabilities, not certainties, that scenario is unlikely and unsustainable.
I do not think all investors should push themselves out the risk curve. Many pension plans, older investors, and others cannot tolerate meaningful downside risk that could materialize. However, many investors sitting in overly diversified and bond-laden portfolios should understand the tradeoffs capital markets currently force on all of us given the likelihood for low prospective returns.
We are currently evaluating our model allocations to reflect these current market realities, which could be lasting. CAPTRUST is committed to help you think through these important allocation decisions and help avoid the collective “Resistance” which may impact you reaching your goals. I have never been as motivated to solve these far-reaching capital market problems on your behalf, and all of us at CAPTRUST look forward to meeting these challenges with you.
[i] Pressfield, Steven, The War of Art: Break Through the Blocks and Win Your Inner Creative Battles, New York: Black Irish Publishing, 2002.
[ii] Beshears, John Leonard and Choi, James J. and Laibson, David and Madrian, Brigitte C., “Simplification and Saving. Yale ICF Working Paper No. 08-07,” Available at http://ssrn.com/abstract=1086462.
[iii] Levin, John and Milgrom, Paul, “Introduction to Choice Theory,” Stanford University, September 2004, Accessed July 10, 2015 at http://web.stanford.edu/~jdlevin/Econ%20202/Choice%20Theory.pdf.