The Tortoise in Your Portfolio

“Rule No. 1 is never lose money. Rule No. 2 is never forget Rule No. 1.”
— Warren Buffett

Buffett’s quote seems to state the obvious, but what does it mean for the average investor? My translation is this: Chasing the big market gains feels good, but protecting against market losses is what leads to a secure and stress-free retirement.

This article will first illustrate the power of preventing market losses, and then will discuss five options for protecting a portion of your portfolio. But first, let me be clear: These defensive schemes are for a portion of a portfolio. In my previous article on the stock market outlook, I discuss how much of your portfolio you should consider insulating from downside risk.

Also, if you are young or more than 10 years from retirement, then you can be much more aggressive, so long as you still have an adequate emergency fund to pull from during tough times.

The Tortoise and the Hare

The tortoise-versus-the-hare analogy fits perfectly into what we have seen in the market the past 15 years. Sometimes the market ran fast, other times it ran backward, and sometimes it went nowhere. I played with some numbers and plotted the following turtle-versus-the-hare chart. The hare is how the actual S&P 500 ran from 2000 through 2014. The turtle shows what you needed to do to match the hare if you ever went backward.

Amazingly, if you avoided the four down years (2000-02 and 2008), then in the up years you would have only needed a little more than one-third of the S&P’s gains (37.8%, to be exact) to do just as well as the S&P 500. Here’s the data:



What Are Some ‘Tortoise’ Options for the Average Investor?

So, as I have preached in my previous articles about the stock market outlook and flawed retirement projections, what are some options to inject some defense into your portfolio? I will discuss five here.

Money Market Account

A money market account is insured by the FDIC (Federal Deposit Insurance Corp.). Saundra Latham recently wrote a good article explaining money market accounts, so I won’t go into much detail here. The bottom line is they are liquid (i.e., you can get your money out instantly) and safe (i.e., your principal is protected).

The returns these days are paltry, barely above 0%, but historically that hasn’t been the case. Yields in money market accounts reflect short-term interest rates. Short-term rates were actually around 5% prior to the 2008 financial crisis. We currently are at a cyclical bottom in both short-term and long-term rates, so we should see interest rates increasing in the next few years, which will improve interest rates in money market accounts.

Also remember that inflation has been virtually nonexistent lately, too, so even though a money market account is not generating much interest right now, it is also not deflating in value either.

Certificates of Deposit (CDs)

CDs are safe because they are also FDIC insured. They also offer higher interest rates than money market accounts. However, you do give up some liquidity — banks typically impose a penalty for withdrawals before the end of the CD term. Saundra Latham also has a good article on CDs.

To counteract the liquidity issue, you can build a “ladder” of CDs. For example, you can take the chunk of money you want to protect and equally divide it into one-, two-, three-, four-, and five-year CDs, so that each year you have a CD coming available to you. As each one matures, you can cash it out penalty-free ,or put it into another five-year CD to extend your ladder another year.

This strategy also counteracts interest rate risk. As I noted above, interest rates are at both a short-term and long-term cyclical bottom. By laddering your CDs, if interest rates do begin rising again, you can renew one each year at a higher rate as rates rise.

Equity-Indexed Annuities

I recently wrote an article explaining the fundamentals and types of annuities. Equity-indexed annuities are a type of fixed deferred annuity. They offer safety and opportunity for growth. In return, you give up some liquidity.

During the accumulation phase, the equity-indexed annuity is tied to one or more stock market indices, such as the S&P 500, a European index, and/or an Asian market index. If the market index goes down, your account does not go down with it. (Protection against losses is why it is considered a fixed annuity rather than a variable one.) If the market goes up, you get credited with a portion of the market gains.

So, for example, suppose I put my $100,000 into an equity-indexed annuity tied to the S&P 500 in which I receive a 50% participation rate. During the first period of time, the index drops 20% in a bear market. The value of my annuity would stay at $100,000 (less any annual fees or expenses charged by the particular insurance company). During the second period of time, the index goes up 10%. I would get credited with half of that gain, or 5%, and my annuity value would increase to $105,000 (less any fees or expenses).

Many equity-indexed annuities have required minimum accumulation periods, six to 12 years, for example, at which time you can withdraw the accumulated value and do something else with it, or annuitize it into a lifetime stream of payments. You do have some liquidity during the accumulation phase—typically, you can withdraw around 5% to 10% each year without penalty.

Indexed Universal Life Insurance

Indexed universal life insurance (IUL) works similarly to equity-indexed annuities. The portion of your premium that is not needed to cover mortality risk goes into an equity-indexed strategy, such as what I described above, and builds a cash value within your life insurance policy. It is protected from losses and offers opportunity for growth if the market does go up.

It also has an interesting liquidity feature because life insurance gets very favorable treatment under the tax code. You can access your cash value tax-free by structuring it as a loan to yourself. If you never pay it back, then the loan amount is just deducted from the life insurance proceeds upon your death. Also, the death benefit of life insurance also passes to beneficiaries free of income tax.

You can access the built-up cash value when you need it, or, if you decide you never need to use the cash value, then the full face amount of the life insurance policy will be paid to your beneficiaries.

Bonds — Well, Sort Of

This issue gets sticky, so let’s start simple and then work through the weeds.

If a) you purchase a bond (in contrast to a bond fund, which I will discuss below), b) the bond issuer never defaults, and c) you hold the bond to maturity, then yes, you have an investment where the principal is protected from loss.

As you can see, however, that’s a lot of “ifs.” Now let’s dive into the weeds.

Credit Quality of the Bond Issuer

It goes without saying, but still some people forget, that a bond is a debt obligation of the entity that issues it. You’re therefore counting on the issuer’s future earnings to be enough to pay you both the interest and principal back. That’s also why bonds carry ratings from agencies such as Moody’s, Fitch, and Standard & Poor’s. The credit rating associated with a bond, especially whether it is rated as investment grade or junk status, has a huge bearing on its perceived risk and also its interest rate.

A great recent example of this entire system falling apart was the 2008 financial crisis, in which the buildup consisted of investment banks packaging mortgages of high-risk borrowers and selling them as “investment grade” bonds to the public. Meanwhile, the credit rating agencies were asleep at the wheel and rubber-stamped these bonds as investment grade because the investment banks were paying them truckloads of money to keep the rubber stamp going.

The bottom line is that repayment of a bond is not a guaranteed outcome. The closest bonds we have to a guaranteed thing are those issued by the U.S. Treasury, despite the ballooning federal debt. The reason is that, if the government gets in a real pickle on paying back the bonds, then the Federal Reserve could swoop in, print money out of thin air, and purchase the bonds. This could lead to massive inflation, but your bond would at least be paid back.

You Hold the Bond to Maturity

You have probably read this many times, but it is worth stating again: If you purchase a bond, and then interest rates rise, the value of your bond falls. In other words, interest rates and the value of bonds move in opposite directions.

The reason is simple, and I will illustrate with an oversimplified example in order to show why. The 10-year Treasury bond has been hovering around 2% lately. Suppose I buy a 10-year Treasury bond at a face value (also known as par value) of $10,000. My annual coupon payments will therefore be $200 (2% of $10,000), and at the end of the 10 years I will get my $10,000 back.

Now suppose while I am holding this bond, interest rates go up to 3%. In order for my older 2% bond to be competitive in the marketplace with the new bonds being issued, it has to go down in value. The reason why is my older bond’s coupon payment is fixed at $200 per year, so in order to get a 3% return to compete with the newer bond issues, my bond must decrease in price.

However, it will not go all the way down to $6,667 (i.e., the point at which a $200 coupon would be 3% of the principal value) because at maturity the government still pays me back the $10,000 par value of the bond, so there is also a gain between the price at which I buy the bond and the par value (if I purchase the bond below par value).

This is the point where bond valuations get complicated, because as interest rates fluctuate, the total return of the bond depends on a) the coupon payments, b) the bond’s current price relative to the par value, and c) the amount of time until maturity.

Sometimes you will hear conversation about “duration” risk with bonds. In its simplest form, what duration risk means is that the longer a bond has until maturity, the more sensitive the price of the bond is to changes in interest rates. For example, if interest rates increased 1% tomorrow, then 10-year bonds would see a bigger price drop than five-year bonds.

J.P. Morgan published a report titled “Guide to the Markets” in July. In that report it discussed interest rate sensitivity and estimated interest rate levels at that time for 10-year Treasury bond prices would fall 8.6% if interest rates rose 1%, and five-year Treasury bond prices would fall 4.7%.

My main point with this section is that, unless you plan to hold the bond to maturity, you absolutely have the risk of your bond losing value and potentially being sold at a loss. Many people forget this fact because long-term interest rates have been declining for over 30 years, so virtually everyone who is still holding long-term bonds has only seen them appreciate in value. That will not be the case when interest rates finally start rising again.

Your ability to hold a bond until maturity also depends on whether you directly own the bond or indirectly own it via a bond fund, which we will turn to next.

Bonds vs. Bond Funds

The vast majority of all investors who “own” bonds actually own them indirectly via a bond fund, i.e., a bond mutual fund or ETF. When you own a bond fund, you lose control of being able to hold the bond until maturity and therefore could very likely suffer a loss in a rising interest rate environment.

As interest rates rise, causing the prices of the bonds in the fund to fall, the fund’s net asset value will fall, causing the market price of the fund also to go down.

Theoretically, the fund could overcome this problem by holding all the bonds in its portfolio until maturity, at which time it would get the full par value of the bonds back before purchasing new ones, but in reality this does not happen for a couple of reasons.

One reason is that in order for the fund to remain competitive and attract investors, it will need to pay interest that is competitive in the marketplace. That means if interest rates are rising, the fund manager will be pressured to replace lower-interest bonds at a loss before they reach maturity.

Another reason is that investors come and go from funds all the time. Especially when a fund begins going down in value, investors start fleeing. In a mutual fund, the portfolio manager will then be required to sell some of the bonds at their falling prices in order to meet the cash requirements for redemptions by fleeing investors.

When long-term interest rates finally do begin an ascent, it will be interesting to see what happens with the hundreds of bond funds that have popped up in recent years. As I mentioned earlier, long-term interest rates have been in descent since 1981 when ETFs didn’t exist and mutual funds were just a tiny fraction of the market compared to today. That means we have an entire generation of portfolio managers who have never managed a mutual fund or ETF during a rising long-term interest rate environment.

Therefore, the best advice I can give on this last category is buyer beware and do your homework before blindly purchasing a bond fund.

Tim Van Pelt is a financial planner. You can reach him at [email protected] or (608) 577-9877. This material has been prepared for informational purposes only, and is not intended to provide, and should not be relied on for, investing, tax, legal, or accounting advice. You should consult your own investment, tax, legal, and accounting advisors before engaging in any transaction.

Loading Disqus Comments ...