Retail investors are currently faced with a challenging dilemma, finding the safest and most rewarding haven for their hard-earned savings.
The classic balanced portfolio of 60 per cent equities and 40 per cent bonds that is widely considered the most prudent strategy for retail investors is being challenged by some advisers. The current global economic dynamics are propelled by low-interest rates, a deluge of liquidity and easing of fiscal policy to help economies recover as early as possible.
The cost of all these factors is a threat of galloping inflation in a few years. The increase in government bond yields, especially in the US, confirms that the financial markets fear the prospect of rising inflation is justified even if not imminent. While central banks are committed to printing as much money as is needed to avoid deep recessions, the cost of this strategy is the erosion of the value of money.
But other analysts take a different view and argue that the 60/40 balanced portfolio is still a good standard for retail investors aiming to preserve their wealth without spending too many sleepless nights fretting about the effect of markets turmoil on their wealth. Investment-grade bonds have traditionally provided dependable income streams as they tend to be less volatile than shares. Bond prices also generally move in the opposite direction to share prices, especially when financial markets are in turmoil.
In 2020, this tendency in the movement of equity and bond prices seemed to be no longer valid. Both equity and debt markets experienced substantial falls in value. Equities have now recovered significantly but bond prices are falling as yields keep increasing on market fears of the inflationary consequences of loose monetary and fiscal policies.
Those who believe that a 60/40 balanced portfolio strategy is still the gold standard for retail investors do not deny the risks of inflation eventually eroding the value of money invested in bonds. They, however, argue that investors should hold on to their bond investments because they will continue to provide adequate insurance against stock market volatility. If, as some analysts predict, the equity markets would experience a significant correction because many shares may be overpriced, then the advantages of holding bonds will become evident.
I worry most about those retired people who have invested in junk bonds because they needed the income that less risky assets could not provide in the last decade
The dynamics that drive stock and bond markets are complex. What happens if the current optimism about significant global economic recovery proves to be unfounded? How will markets react when central banks start to reverse the loose monetary policies? What is likely to happen when governments decide to start tightening fiscal policy to address the growing debt mountains that most countries are building to avoid a deeper recession?
While there is no silver bullet that will resolve investors’ dilemma on how much bonds to hold in their portfolio, specific guidelines should be followed to avoid the cost of taking excessive risks. Many investors have been buying risky assets in their desperate search for yield. Unfortunately, market regulators and investor protection authorities have failed to highlight sufficiently the folly of buying risky assets that could destroy the nest eggs of small investors.
Investment in blank cheque companies, cryptocurrencies, junk bonds and real estate should come with a bold printed financial health warning. Of course, some may have a much bigger risk appetite because they can tolerate market swings without their lives being too negatively affected.
But older people, who have shorter time horizons, need to have lower-risk stabilisers in their portfolios. I worry most about those retired people who have invested in junk bonds because they needed the income that less risky assets could not provide in the last decade.
The governments’ and central banks’ commitment to buy corporate debt may have saved some companies from closing down during the pandemic. But when this commitment is withdrawn to protect taxpayers from rescuing insolvent businesses, the debt holders would suffer painful consequences.
There is no one-size-fits-all solution to the bonds investment dilemma. Investors with a low risk tolerance need to focus on the choice of assets they include in their portfolio to ensure that their capital is protected from dramatic falls in value. The search for yield should never be such that it exposes small investors to wealth destruction if equity and debt markets suddenly go into turmoil.
Some risky assets have a place in the portfolios of those who can absorb market shocks. But the higher returns that risky assets could provide come with increased liquidity and default risks that only those with significant wealth buffers can absorb.