Typically, when investors talk about conservative strategies, investments in bonds come to mind. However, recent announcements seem to change that view. UBS, for example, is viewing bond investors increasingly as aggressive investors as shown in the following two excerpts from a recent publication:1
UBS is planning a mass mailing to many of its brokerage clients alerting them that they have been reclassified as “aggressive” investors following a recent change in its market outlook that some people inside the firm say reflects growing bearishness in the bond market, particularly over the long term…
According to brokers inside UBS, new guidelines will reflect a growing belief among the firm's market strategists that the bull market in bonds has largely run its course, and that those investors who believed they had constructed a “conservative” portfolio by being heavily invested in bonds could be reclassified as “aggressive.”
The reclassification of bond investors occurs largely because of expectations that interest rates—currently at an all-time low—will have to go up sooner or later. When interest rates go up, bond prices drop. If you are selling your bonds during rising interest rates, you could experience investment losses. According to a CNNMoney survey, 70% of investment experts expect interest rates to rise within the next two years.2
We may still be years away from rising interest rates. Nobody knows for sure. At Cornerstone, we don’t invest in prediction, but in preparedness. That means we don’t pretend to know what will happen. But we try to invest in a way that we are prepared for different outcomes. One way to prepare for different scenarios is by diversifying across multiple asset classes. If interest rates rise significantly, you don’t want to be heavily invested in bonds. If they don’t rise, you may want to have some bonds. That’s why we believe proper diversification can address different outcomes.
For example, let us look at inflation as a possible outcome. The following chart3 shows how different investments have reacted differently to inflation. The chart demonstrates the correlation of the investments listed on the far left to inflation. A correlation of 1 means the investment is perfectly correlated with inflation. That means it will move in lockstep with changes in inflation. As the correlation moves closer to zero, the less correlated an investment is to inflation. An investment that is negatively correlated to inflation moves in opposite directions as inflation. Again, a -1 correlation is perfectly negatively correlated (when one goes up, the other will go down with the same strength). The closer the negative correlation moves towards zero, the less correlated the investments are.
In the event of hyperinflation, being invested in long-term treasuries may not be to your benefit. But investments in commodities could be beneficial. There is a time and place for every investment. Knowing the exact time and place is impossible. But that doesn’t keep you from being prepared. Just as you may want to have a surf board and an umbrella in your trunk in order to be prepared for sunshine and rain, we believe you should have different asset classes in your portfolio to be prepared for different economic events. The stigma of protecting your assets by staying in bonds may no longer hold true.
3 Pimco Connect: Investment Update, PIMCO All Asset and All Asset All Authority Funds Update, Q4 2012, page 12, citing Bloomberg.