Expert outlook: Analysis from the 2012 IMCA and CFA conferences

A 30-year bull market in bonds has created unshakable complacency among baby boomers nearing retirement.

But anyone ignoring alarming government debt levels in the developed world, and the policy of protracted low interest rates, does so at his own peril.

There is a tremendous opportunity for financial advisors to educate clients about escalating risks in fixed-income portfolios and propose a successful retirement strategy that copes with these challenges.

Changing the conversation won’t be easy, said Michael Jones, founder, and chief investment officer, of RiverFront Investment Group, speaking at the annual Investment Management Consultants Association (IMCA) 2012, in National Harbor, Maryland, near Washington D.C.

“Clients are still massively buying fixed income and they’re redeeming out of equity in droves,” he said. “The conversations we gotta have are incredibly challenging.”

The goal, he said, has to shift from meeting a benchmark to putting cheques in the mailbox. Retirees need to evaluate if their income levels are stable and have capacity to grow.

Today’s environment dictates risk management focus less on the absolute value of the client portfolio and more on stability and predictability of income it can generate.

Jones breaks it down. “When you pay a low price for an asset class, good things happen,” he said. “In bonds, the interest rate you get is the price you pay. Low interest rates, high prices. High interest rates, low prices.”

Current historic low interest rates have driven bond prices so high that when rates finally start going up, bond prices are going to come crashing down.

“There was a period of time [in the 40s and 50s] where, for about 14 years, interest rates were about where they are now and they didn’t go up,” said Jones.

As a result, clients didn’t see a big loss in their monthly statements. In reality, investors in fixed income lost 40%-50% of portfolio value during that period.

“How many of your clients, if they suffered a 40-50% loss in the purchasing power on the part of their portfolio that’s allocated to fixed income, could have a successful retirement?” he asked.

This historic precedent, therefore, doesn’t make Jones feel better about the potential for the current environment. He has good reason to feel that way.

Clients, he said, have earned absolutely nothing over the past three to four years, having experienced 14% to 15% cuts in their money market funds, while inflation shot up 13% to 15% for the same period.

“And yet nobody complains because they never connect the fact that a big chunk of their portfolio is not keeping pace with the rising cost of living,” he said. “We believe that this is the future of fixed income investors.”

Jones makes the case for equities using the same period in history, during which “stocks returned 75% over and above the rate of inflation.”

He wants the conversation to turn to equities. “We have to start getting investors to recognize that right now, unfortunately, there is no risk-free investment,” he said. “In a world of zero interest rates, choose your risk [wisely].”

If investors chose bonds, they are certain to lose money relative to inflation. Even in the best-case scenario, he said, the feds will leave rates at zero and clients will “die a death by a thousand cuts.”

In the worst-case scenario, the feds will raise the rates which will be “devastating to the value of the bond portfolio almost immediately.”

“And yet, month after month, investors are ignoring the opportunities in equities so that they can keep flooding into the presumed safety of bond,” said Jones who defines safety as stable income that people can count on over time.

The solution lies in dividend-paying stocks. “Stocks pay income that grows over time, very predictably, very reliably,” he said. “The most predictable [asset class] I have ever studied relative to inflation, is the dividend off of a stock.”

There are, however, no free lunches. The reason why this incredibly attractive income package is available to investors is “because is comes attached with a price that goes up and down in ways that make us crazy.”

Although it’s impossible to predict with 100% accuracy, over the next 10-to-15 years Jones says stocks will return 6% to 7% above inflation. In the shorter term, though, it’s harder to make the call. So ensure clients who go into stocks have some time horizon to work with.

Right now is a good entry point, he adds, because stocks are “about 20% below the long-term trend” and because “historically, during periods which begin with [valuations that are] 20% below the long-term trend, investors have made money relative to inflation.” This has happened 95% of the time during the five years following the value drop—even in the Great Depression.

There’s just one little catch. Every time the market’s been this cheap, there’s been something to be afraid of—volatility.  “You go through psychological swings of optimism and areas of pessimism,” said Jones.

That said, bonds are currently priced in a way that investors are almost certain to lose money. Stocks, on the other hand, are priced where clients are almost certain to make money over the next five years, “but they’re going to put you through hell.”

It is this observation that leads Jones to create his unique asset allocation strategy. His portfolio is 60% stocks that look like bonds and about 25% bonds that look like stocks.

He has been bulking up on lower volatility stocks left behind in the market and taking more risk in his stock portfolio from a percentage standpoint, keeping the actual volatility of stocks low. In his bond portfolio, instead of having a lot of treasuries and investment grade corporates, he has a lot of high yield and emerging markets.

“There is no risk-free asset,” said Jones. “You’ve got a high probability of loss over a five-year period in the supposedly safe stuff [and] a high probability of gains in the supposedly risky stuff.”

In the end, stocks are worth the risk as they offer better returns for your retirement. Still, investors may need more Zantac along the way.

Originally published on Advisor.ca