The Price Of Staying Out Of The Alligator Pit
Justifying Good Risk Management
By Ryan J. Guttridge, CFA
When I was very young, my parents took me and my sisters to the zoo. I found the alligator exhibit to be particularly frustrating, as the alligators were motionless and uninteresting. I began searching for a way to provoke a reaction. Since there was nothing handy to throw at them, I settled on the only thing readily available one of my new shoes. With my parents attention focused elsewhere, I took off my shoe and tossed it toward the motionless alligator. Of course I missed. The alligator didnt move and I immediately panicked realizing I now only had one shoe.
Fortunately my parents were still distracted and hadnt yet noticed what was going on. This alligator had a solid track-record of not moving, so I figured I could climb over the railing and retrieve my shoe. Additionally, it was a really bad throw, so the shoe was close. However, my mom didnt share in my confidence and grabbed me just as I was getting started. Needless to say I didnt appreciate being stopped in my tracks then, but with the benefit of time Ive come to realize she probably made the right call.
The Role of a Financial Advisor
Good financial advisors have much in common with my mother. The most important service a financial advisor provides is that of a risk manager. Simply put, losing money is more damaging to ones retirement plans than trying to maximize returns. Successful investors strive to avoid situations where significant losses can occur. Since no one has a crystal ball, investors must take steps before something bad happens and they potentially leave money on the table. This means occasionally foregoing investments that could have had great returns. My mother didnt know what the alligator would do, but it seemed the risk outweighed the potential benefit of getting back my shoe.
An Area to Avoid
Bond funds, or funds predominantly invested in bonds, have been great performers over the last decade. Bonds gain value when interest rates fall and since interest rates have been falling steadily, bond values have been going up. This means the shares of mutual funds that own bonds have gone up. This has given rise to a counter-intuitive situation which isnt sustainable. The traditionally more conservative bond funds have outperformed the conventionally riskier stock funds. While long-term interest rates are around 2.0 percent, they will have difficulty falling further. In fact, history tells us it is far more likely that the rates will rise. Below is an example of the losses a 10-year, 2 percent government bond could endure should that happen. A reversion to average interest rate levels is demonstrated below indicating that losses of over -30 percent are possible, which could be very damaging to any bond fund.
The Price of Staying Out of the Alligator Pit
Good risk-management decisions can be hard to justify because they are actions taken to avoid something which may or may not happen. No one knows if rates will rise and it cant be said that interest rates cant drop because they can. For instance, the circumstances last year were similar and this strategy had a price. The most widely followed bond index was up almost +8.0 percent. This easily beat stocks, which struggled to eke out any gain. Should rates continue to fall, bonds and bond funds will do well (as the chart indicates). Yet despite this possibility, it doesnt make the decision to avoid bond mutual funds wrong. The key question is, Does the return justify the potential downside? Currently, for many bond funds the answer is no. The conversations you have with your financial advisors should concentrate on your goals, the minimum rate of return that will achieve them, and how to avoid areas where the risks are too great to justify the returns. Make sure you are talking to your financial advisor in these terms.
Ryan J. Guttridge holds the Chartered Financial Analyst designation and serves as Chief Investment Officer at Middleton Gardiner Group, LLC in Severna Park, MD. If you would like to speak with Ryan about your financial situation, he offers a free initial consultation. To learn more, please call 410-975-0099, visit www.mggadvisors.com, or email Ryan@mggadvisors.com.