You know the old adage; “There ain’t no such thing as a free lunch”? Well, it is true in the world of economics as much as in any other context, and commonly the quote is attributed to the great economist Milton Friedman. We’re going to talk a little bit about that quip this month so you have some perspective and appreciation for how it plays out in your investments.
The alluring ‘lunch’ in regards to investments can be “liquidity” (how easy is it for me to get out of something), or it can be “stability” (how much / little does that doodad fluctuate). However, the lunch is generally related to “return” (how much do it get back per dollar put in). Again, speaking in industry terms, the vernacular for returns is not dollars, but an annual percentage return so that we can easily compare investments regardless of how much we put in, be it a dollar or $32,922,388 dollars.
Now that we have that morsel knocked down, let’s look at the two primary categories for investment; one is Bonds (also called the fixed income category) and the other is Stocks (also called equities). Well, actually, to flush out this dialogue and bolster your education, I will disclose that the third area for investments is called Cash (checking and savings accounts, Short-term Treasuries, CD’s). However, as cash is such a poor returning category these days we’ll just consider it a really poor lunch and not even talk about it here as a viable item on the investment menu.
Having laid those definitions out, let me take you onward to the insight. A VERY important slide is below from JP Morgan’s Market Insights publication[i]. This particular graph shows the 10 Year Treasury history of yields over time and the ‘real rates of return’ (what you get after inflation takes its chunk out). The slide shows a lot of information but let me focus your attention to the two little boxes on the bottom left and right. Therein is ‘the price of lunch’.
In these days of endless speculation on when interest rates will go up, you will note the average returns of both Bonds and Stocks juxtaposed to each other, quantified both before and after inflation. The remarkable element that I want you to take away from this monthly lesson is twofold;
- That equities outperform bonds whether interest rates are heading up (right slide) or down (left side).
- That inflation can eat up 100% or more of the returns on bonds (see negative number on the left side; -2.0%) and will hurt but don’t eviscerate the returns on equities.
It is not immediately evident here, but one proactive way that you can protect yourself against possible rising interest rates is to NOT own longer term bonds / Treasuries. A 10-yr Treasury is long-term, and it got hurt in some of these periods as you can see, which is exactly why you don’t own any long term bonds in your portfolio. Period.
Now, we have not gone nutsy here so you don’t have a portfolio of all stocks / equities, but rather own a combination of stocks and shorter-term bonds. That combination gives you much of the upside of stocks, but is balanced against the downside volatility by the use of investment grade bonds (highest quality stuff) with shorter maturities.
Where all this thoughtful history leads is this; we have tried to position your portfolio so that you really have a nice basket of investments, but yet one that is protected against inflation eating your lunch.
[i] “Guide to the Markets” (JP Morgan Asset Management, Market Insights Group, March 31, 2015)
