Common Sense: A Prize-Winning Plan for Investing When Interest Rates Are Low

Squeezed by historically low interest rates, a wide range of investors — from retirees living on fixed incomes to huge endowments and pension funds trying to meet budgets — are trying to figure out how to generate income.

Some Duke University undergraduates think they have the answer.

Business and economics programs at American colleges and universities have long sponsored stock- and other asset-picking contests for their students. But last semester, faced with the current ultralow interest rate environment, Duke’s undergraduate economics department ran a competition in asset allocation for the first time. Students had to decide what percentage of assets to put in fixed-income investments and what percentage to invest in other categories. The asset management firm BlackRock was a co-sponsor of the contest, which was open to any Duke sophomore or junior.

“Where is someone supposed to get yield these days?” said Emma B. Rasiel, an associate professor of economics. “That’s what got us thinking.”

It’s a pressing question for nearly every investor, and has left even professional financial advisers scratching their heads. The United States is now in the fifth year of a low interest rate environment. Ten-year Treasuries, the benchmark United States interest rate, yielded 5 percent in July 2007, just before the recession began. This week, the rate was below 2 percent, and last July, 10-year rates were the lowest ever recorded. This week, the one-month Treasury bill, the lowest-risk bond investment because of its short duration, was yielding practically nothing: 0.04 percent.

How much of their assets to allocate to bonds and other categories may well be the most important decision investors make. The mutual fund giant Vanguard advises, “Research shows that your asset mix — how you spread your money across stocks, bonds and cash — has a far greater impact on long-term returns than your individual investments.”

For many years, the rule of thumb for most long-term investors was “60/40,” a 60 percent allocation to stocks and 40 percent to bonds. Besides having the virtue of simplicity, less volatile and lower-return bonds were meant to smooth out the ups and downs of the riskier stock market while giving investors some of the greater possible gains of stocks. Vanguard estimates that an investor with a 60/40 allocation can expect an average annual return of 8.6 percent, based on data going back to 1926. That allocation resulted in a decline in 21 of the next 86 years. In the worst year, 1931, it resulted in a drop of 26.6 percent, while in the best year, 1933, it produced a gain of 36.7 percent.

By comparison, a 100 percent allocation to stocks produced an average annual gain of 9.9 percent, with a decline in 25 of the 86 years and much greater volatility. A 100 percent allocation to bonds resulted in an average gain of 5.6 percent, with a decline in just 13 of the 86 years.

But those are long-term averages. The results can vary substantially depending on the starting point. In the decade ending in 2009, stocks had average annualized returns of negative 3 percent and lagged bond returns by more than 9 percent, a record disparity, according to T. Rowe Price.

Hardly anyone expects those high bond returns now. Despite the paltry yields, fixed-income investors have been cushioned for the last few years by falling interest rates, which allowed the value of their bonds to increase as yields declined. (Bond prices move inversely to interest rates.) But with short-term rates now near zero and longer-term rates still at historical lows, it’s almost impossible for rates to decline any further. Indeed, they have been creeping up in recent months. And if and when rates rise more substantially, bond investors will be stuck with not only slim yields, but also losses on their principal.

Given this, should investors abandon the tried-and-true 60/40 approach and move more aggressively into stocks?

“The traditional 60/40 approach to building a portfolio is on the way out,” said Michael Fredericks, head of retail asset allocation for BlackRock and lead portfolio manager for the BlackRock Multi-Asset Income Fund. It is being replaced, he said, by “tactical” asset allocation, a strategy in which investors change their allocation based on the current pricing of asset classes.

Article source: http://www.nytimes.com/2013/02/02/business/a-prize-winning-plan-for-investing-when-interest-rates-are-low.html?partner=rss&emc=rss