Diversify Before the Bond Bust

One asset class that you should be wary of today is bonds. A piece of conventional wisdom is to allocate half of your portfolio to bonds, as ballast in case the stock market teeters again. Think twice about that.

Risk management is the key to long-term performance, and a diversified asset allocation is the best way to achieve this. Too often, investors seek big short-term returns when their focus should be on return performance with preservation of capital over three, five and 10-year intervals.

Moves by the U.S., European and Japanese central banks help the global picture improve right now. But how long can it last? The Federal Reserve said that it plans to keep interest rates low until employment improves, but their efforts cannot stem the tide forever.  It’s inevitable that interest rates rise at some point, drastically reducing bond prices. And yet, many still keep the exact same type of asset allocation they had since the 1990s.

Why put your money into bonds, an investment offering 1.5% return for 10 years, knowing that once the Fed changes rates they plummet in price? For many, the reason is fear. The fear of volatility and a global downturn is so prevalent this spring that many investors are looking for asset preservation rather than growth.

Since we know that rates and inflation are bound to increase, the risks you take on bonds can be devastating. When interest rates rise, owners of long-term bonds lose the value of both their bond holdings as well as the opportunity cost in other investments they ignored.

As the Federal Reserve enters its fifth year of loose monetary policy, even its own members are saying that interest rates should rise sooner rather than later. This is a clear signal that 2013 is the year to examine the asset allocation, particularly regarding bonds and other assets sensitive to rising interest rates.

There are many great reasons to spread your investments across a range of asset classes, even when some are clearly outperforming the others. First, what comes up goes down. Think of those who had too much of their wealth tied to real estate a few years ago or dot-com growth stocks at the beginning of the century. Had they diversified, the bust would not have been so painful.

Let’s say that a very aggressive investor, who could accept high risk, allocated 15% to 25% of his portfolio in tech stocks back in 1997 or real estate investments in 2004. In either case, if those investments grew to 45% of his portfolio in 1999 and 2006, then that is a red flag to reduce the holdings back to the original weight.

Typically, if an investment overshoots upward, it tends to overshoot downward, as well. Risk management and diversification involves moving money to other investments that are not likely to plummet as much – and have potential to grow when these investments fell.

Diversification is about more than just trying not to lose or placing eggs in multiple baskets. There is always a booming market out there, and rarely can you ever guess to jump in full bore right before it starts to climb. Most importantly, good diversification decreases your overall risk exposure to extreme market downturns, creating a shield for large losses of capital.                                                                     

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Walid L. Petiri, AAMS, RFC, is chief strategist at Financial Management Strategies LLC in Baltimore, Md. 
 
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