Starting 2012 on the right foot

It’s a new year, so here are a few investment and retirement thoughts that come to mind for 2012.

When it comes to investing, Theme #1 among investors, especially among the majority of the retired or conservative crowd, continues to be the insatiable search for yield. In this regard, I would encourage investors not to be misled by the spectacular total returns on fixed income markets. Long-term Treasury bonds were up 30% in 2011 (as measured by the Barclays Long-Term Treasury Index). That substantial total return arose mainly from a large capital gain due to falling interest rates. (Recall the sequence: Panic about Europe and a volatile U.S. stock market led to a flight to Treasuries by global investors, which drove up bond prices—i.e., resulting in a capital gain on bonds—and consequently drove down their yields.)

A better long-term outlook for prospective bond market returns are current yields (the amount of current income relative to the bond’s current price), which are at much lower levels. On the day that I’m writing, a 10-year Treasury bond yields around 2%. High-quality corporate bonds are 4% or more. These are more indicative of expected future bond market returns over the long haul than any recent reported total returns, which combine (large) capital gains and (skinnier) interest yields.

As yields from money funds have evaporated, and CD yields have fallen to around 1%, many Vanguard clients have “stretched out the yield curve,” moving to bond funds with longer durations and higher current yields. These funds come with greater risk, so investors need to be fully aware of the risk as well as their current higher yields.

I know some investors are strongly opposed to buying bond funds for precisely this reason. Their fear is that interest rates will move up, and bond prices will fall dramatically. It’s not a theoretical worry. In 1987—way back when I joined Vanguard—some of our bond funds fell 15% in principal value between the spring and the fall as the Fed and bond market reacted to strong economic data. Today, bond yields are at historic lows, and so the odds are for eventually higher yields and falling bond prices. That leaves some investors skeptical of bonds from a market-timing perspective.

Our research has shown this reasoning isn’t quite right. A lot depends on your holding period and the actual timing of the change in interest rates. Interest rates could stay low for a long time, meaning principal risk would remain low as well. But today’s bond market investor should be wary of the downside risk—and think hard about it.

For those not currently retired, Theme #2 is about revisiting savings rates. At Vanguard, we have a rule of thumb that investors in their accumulation years should be saving 12–15% of their income (including whatever money your employer adds to retirement accounts). That’s only a rough rule of thumb, and it’s a very useful exercise to use an online calculator to refine your own estimate. In the end, the bulk of long-term wealth accumulation over the next decade is likely to come from what you save, not what you earn—assuming that the climb out from the 2008–2009 crisis is slow and uneven.

Theme #3 is the equity markets and their role in your portfolio. Given the large amount of household cash that has flowed into bank CDs and bond funds, we continue to debate whether many investors have simply become too shell-shocked to add to risky asset holdings. But to me, risk has always been not a question of either-or (Should I be in the market—or not?) but one of degree (What fraction of my total wealth should be in equities?).

If you look only at tradable financial assets, my own allocation (at age 54) is 62% equities, 23% bonds, and 15% cash, with the equity position about 70% domestic and 30% overseas. I can imagine being somewhat more risk-seeking (70% equities or somewhat less, around 50%), so I suppose that I’ve reached some uneasy psychological equilibrium. In a small concession to market timing, I continue to defer investing the cash position in either bonds or equities, though the opportunity costs are high, as the money is earning essentially zero. (Of course each investor is different, and so your portfolio allocation should be based on your own circumstances—not mine.)

By the way, tax time is the perfect time to make sure you have these asset allocation figures updated. Write down all of your asset holdings as of year-end, from all accounts and sources, add up the value, and calculate each holding as a fraction of the total. You can divvy up holdings among the three more common categories (stocks, bonds, cash), and, in a more extended version, add in real estate (which I would show net of debt) and other assets (e.g., gold, commodities, collectibles, and even private business holdings) if they figure into your portfolio.

Whenever I’m asked about Vanguard funds, I first ask how the person’s current portfolio is allocated. In many cases, the questioner doesn’t have the answer top of mind. But it should be, as it provides insight into your aggregate risk exposure. It’s really one of the standard financial tasks we should all complete at the start of a new year.

Note: All investing is subject to risk. Be aware that fluctuations in the financial markets and other factors may cause declines in the value of your investments. There is no guarantee that any particular asset allocation or mix of investments will meet your investment objectives or provide you with a given level of income. Diversification does not ensure a profit or protect against a loss in a declining market.