The Goldilocks Strategy for Prudent Investors

By DAVID A. LEVINE


ARE you saving for retirement but worried about how to handle a sudden, unexpected expense? Or already retired and wondering how best to protect yourself against a stock market loss?

Many people with those fears set aside a so-called rainy-day fund, keeping large sums in their bank accounts or money market funds. This is a costly mistake, rivaled only by the excess fees too many investors pay to high-cost money managers.
 
When I ask people why they do it, they say things like “in case I wreck my car” or “in case my house burns down” or “in case I have a medical emergency.” But problems of this sort require large cash outlays only if you are not insured. And the remedy for this is to make sure you are adequately insured, rather than create a big rainy-day fund that earns vastly inferior rates of return compared with stocks and intermediate-term bonds.
 
You will need a lot of cash, of course, when you retire or if you join the ranks of the long-term unemployed. Under those circumstances, however, you will need that money over a protracted period of time. There is no reason that the resources to finance this spending stream should take the form of low-interest bank deposits or money market funds, which inevitably will fail to keep up with a rising cost of living, even if inflation remains modest.
 
Instead, to minimize the real risks we all face in meeting our unknown, long-term financial obligations, you need a different strategy, one that produces reliable, spendable cash flow and superior returns, minimizing the likelihood that the inflation-adjusted value of your portfolio will decline over time.
 
The best way to achieve those goals is to avoid “perfectly safe” cashlike assets, relying on your savings account or money market funds only for a 30- to 60-day cushion to cover your day-to-day obligations, plus enough extra at times to satisfy those occasional outsize expenses like a child’s college tuition bill that is due in the next few months.
 
After that, your primary goal is to build wealth. Not surprisingly, equities do best. That’s why most of your money for your retirement should be invested in stocks.

But you may not have realized that intermediate-term bonds, over the long run, are superior not just to cash but to long-term bonds as well. So when thinking about where to invest your fixed-income assets, remember Goldilocks: The best place to be is not too long and not too short.
 
The return you expect to earn and the risk associated with bonds rise as maturity lengthens. But the rates at which they rise are neither uniform nor equal. At first, as you move out of cash into short-term bonds your expected return rises rapidly, but risk — if we define it as the chance that you will lose to inflation — actually diminishes.
 
That’s why the shortest-maturity investments like money market mutual funds and Treasury bills are among the worst investments you can make.

 
The Real Risk in ‘Risk-Free’ Investments 
      
Short-term Treasury bills, like bank accounts and money market funds, are sold as risk-free investments. But for anyone saving for the long term, the returns would barely keep up with inflation, and would be eroded even further after taxes. By contrast, stocks and intermediate-term bonds offer the greatest rewards compared to the risks that they will underperform over shorter periods.

As you then extend your maturity from short-term bonds to intermediate, the increase in return slows down and risk begins increasing, but the trade-off between the two seems commensurate. Extend your maturity beyond intermediate, however, and the additional expected return that you gain seems wholly inadequate compared with the amount of extra risk incurred.
 
With long bonds you are at the mercy of the inflation gods: If inflation is low enough, you can win big; if it’s high enough, you get buried.
 
The moral of the story: Don’t put your money in long bonds (too risky) and don’t put your money in money market funds or bank accounts. The latter give up way too much return for the (supposed) perfect safety of zero fluctuation in the value of your investments.
 
Instead, the place to be is what is essentially a large “sweet spot” between short and intermediate. That’s where the reward-risk trade-off is at its greatest.
 
But what about those of you who have been investing in long-term bonds, which have done very well since the early 1980s? All I can say is: Fabulous market timing! As Morningstar reports, for the 34 years ending 2015, long Treasuries offered a compounded return of 10.1 percent per year, a pace that was much better than intermediate Treasuries’ 7.5 percent and not all that unfavorable compared with stocks’ 11.5 percent.
 
But it’s worth remembering that at the end of 1981 long Treasuries were yielding more than 13 percent and were about to begin a decades-long decline that produced hefty capital gains. With long-term Treasuries now yielding just 2.3 percent (and yields on non-Treasuries not much higher), you are all but certain to have inferior returns on long bonds unless we enter an extended period of deflation. With the unemployment rate at a low 4.7 percent and underlying inflation running around 2 percent, I would not bet on that.
 
Indeed, long-term bonds can be a horror show. Over the long period that stretched from 1940 to 1981, long-bond returns averaged 2.2 percent while inflation advanced at a 4.7 percent annual rate.
 
The value of such assets dropped nearly 63 percent in real terms, even if you never spent a dime.
 
After taxes, you would have lost 70 to 75 percent of your money.
 
Fortunately, not many investors keep a large share of their funds in long bonds. Many more fall prey to the irrationally strong preference for perfect stability: Bank accounts and money market funds capture almost 30 percent of individual investors’ liquid financial assets.
 
That’s a sucker’s game, with no chance to earn the higher coupons that are routinely paid by bonds with modestly longer maturities. For the 90 years ended 2015, investors gave up 1.7 percent a year, compounded, if they stuck to Treasury bills instead of being willing to invest in intermediate Treasuries.
 
Obsessing over downside risk costs investors a great deal of money, reducing their standard of living in retirement. And speaking of not obsessing over acceptable risks, it’s even better to avoid Treasury securities in favor of low-cost mutual funds that invest in either corporate or municipal bonds. The extra yield these bonds pay (after tax) swamps the tiny costs they incur on those rare occasions when bond issuers default.
 
The point of accumulating assets is not so that you can spend them down quickly in retirement, for once you spend them, you are broke. The point is to mainly rely on the income they produce.
 
And, of course, income does not mean simply nominal income, but real (inflation-adjusted) income.
 
And in this regard, equities do best, while within the universe of fixed-income investments, intermediate maturities offer you the best odds of beating inflation during the course of your lifetime.

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