Chicken Little could be right: Are your clients sitting on a ticking time bomb?
By Jason Kestler
Kestler Financial Group, Inc.
Advisors are paid to manage people’s money, but we don’t have crystal balls. Instead, we conduct a thorough examination of the client’s needs. We analyze assets, risk tolerance, time horizon and goals, and we make recommendations that are in the best interest of the client. Or do we?
In 1952, Harry Markowitz won the Nobel Prize in Economics for Modern Portfolio Theory. Markowitz's theories emphasized the importance of portfolios, risk and the correlations between securities and diversification. His work changed the way that people invested and the way we advised our clients.
In simplest terms, Markowitz stated that for any given risk tolerance, there is a specific combination of asset classes (small cap, mid cap, large cap, bond, international, etc.) that will provide the highest expected return with the lowest associated risk. This is known as the Efficient Frontier.
Although there is quite a bit of fine tuning within each sector, an efficient portfolio is some combination of equity (stocks) and debt (bonds). The bond portion would increase as the client’s risk tolerance decreased.
Modern Portfolio Theory has been the backbone of the investment community for over 60 years and it has done a very good job. Now, look deeply into your crystal ball. On second thought, just look around you. What do you see?
- FINRA issues an investor alert, “Duration — What an Interest Rate Hike Could Do to Your Bond Portfolio.”
- Bill Gross, arguably the most successful bond manager ever, tweets “the 30-year bull market in bonds likely ended April 29.”
- Warren Buffett, the “Oracle of Omaha,” was recently quoted as saying, “Right now, bonds should come with a warning label.”
In case your crystal ball is on the fritz, the chart below is what it’s trying to show you.
Do you have any doubt that we will see interest rates rise over the next five to 10 years? Now, imagine your clients who are desperate for yield and have purchased long-term bonds. If we see just a 2 percent increase in interest rates, their bond will fall in price by 23 percent! In other words, their $100,000 bond portfolio just lost $23,000. Are they aware of this risk? Are you telling them about this risk?
I don’t mean to be a Chicken Little, but let’s take my hypothetical one step further.
Interest rates rise by 2 percent. Clients see their bond holdings devalued by 23 percent. What will they want to do? Sell! What happens to any item where there is a high supply and a low demand? The price is depressed even more. Chicken Little could be right.
So, why would you recommend that a client should buy (or hold) an asset that you know will lose money. Where else can you go?
Why not consider a new asset class with the following characteristics?
- No downside risk in a rising interest rate environment
- In fact, no chance of ever seeing a negative return
- Daily price availability, just like bonds
- A fixed asset that effectively shifts the efficient frontier
So, what’s the take away?
1. As you meet with clients who have bonds in their portfolio (401(k), investment accounts, variable annuities, managed money), consider repositioning all or a portion of the bond to an FIA. Same asset class, lower beta (volatility).
2. Examine your current book of business. Are there clients with assets currently sitting in bonds or bond funds?
3. Have the conversation with your clients. Do they have friends or loved ones at risk?
You can see the storm brewing. Your crystal ball is tuned in perfectly. The big question is, will you act on the information?