Fight the Urge to 'Correct' Recent Experiences
by Breck Anderson
Painful lessons shouldn't drive decisions you make with investments.
I entered the financial advice business in 1985, in the early stages of what has now been a 27-year bull market for bonds; interest rates have declined throughout my career. Between June and December of 1980, Federal Reserve Chairman Paul Volcker “broke the back” of inflation by raising the Fed Funds Target Rate from 8½ percent to 20 percent.
Many of us who are over 50 drove to our first career jobs in cars we bought with an 18 percent loan. Our parents and grandparents who financially survived the economic and stock-market chaos of the ’70s were briefly presented with a historically unique environment to invest in the highest-yielding quality bonds ever. The few clients I had in the summer of ’85 could buy a 15-year, AAA-insured federal- and state-tax-free municipal bond yielding 10 percent.
But bond investors then were fearful after years of stagflation and recent experiences with rising rates. Fed policy and economic conditions caused the yield curve to invert (short-term rates were higher than long-term rates). Thus, the investing public was enticed to buy a 1-year AAA insured municipal bonds—federal and state tax-free—yielding 12 percent. Investors became speculators on the future direction of interest rates by plowing most of their capital into short-term instruments. And therein lies the greatest challenge of investing in securities: We must insulate ourselves from reacting to our most recent experiences and invest capital for when the tide turns, as it always does, avoiding behavioral prejudice.
Investors now view bonds as a safe haven. This makes sense in the context of a long bond bull market and a decade of negative equity returns. As the New York Times noted last month, “over the last 207 years, you got paid 2.5 percentage points more each year (on average) to invest in stocks than you did in bonds.” The amount you are supposed to earn above cash and bonds for the additional risk of stocks is the risk premium.
But in an article in The Journal of Indexes, Robert Arnott highlights multiple 20-, 30- and even 40-year periods where we would have been better off in bonds. In other words, the risk premium did not exist. The Dow Jones Industrial Average, at this writing, is 9,886; it closed at 10,970.80 on June 30, 1999. During the past 11 years, it has endured two declines of 50 percent, reaching as high as 14,198 and as low as 6,469. Today, like the early ’80s,
we are being presented with unprecedented conditions that can easily influence our investment behavior.
An investor's mantra should be “I diversify because I do not know for sure when the tide will turn.” The tide, of course can be the economy, interest rates, the stock market, unemployment, commodity prices, new home sales, retail sales and other variables. A 1986 study by Gary Brinson, the money manager, concluded that investment success was more likely to be caused by being in the right type of investment than any other factor—even more than being in a certain specific security, stock or fund.
The results of his study suggest that roughly 93.6 percent of investors’ long-term returns come from asset allocation, vs. 6.4 percent being in the right security at the right time. This idea can be applied specifically to bonds, as there are many different types. For example, if you think tax rates may soon be going up, Tax Free Municipal Bonds are attractive for their tax-free interest as the net after-tax effect improves. The Federal Reserve is fighting deflation with an unprecedented low Fed Funds Target rate of 0.25 percent (the extreme opposite scenario of the early ’80s). It seems logical that inflation will one day accelerate; if you agree, you can invest part of a bond allocation to Treasury Inflated Protected Securities.
Today, interest rates are low. They won’t always be. To protect against rising interest rates, ladder your bonds and Certificates of Deposit so that each year, you have an opportunity to reinvest in new bonds that may pay higher rates of interest or reallocate some to stocks. Bond Funds and ETFs (Exchange Traded Funds) allow for simple diversity and a means to invest in more complex bond instruments such as Convertible Bonds; but no matter the duration of Bond Funds, they do not have a maturity date and can quickly lose value when interest rates go up.
The investment business has taught me to watch out for what investors are doing with their capital based on recent experiences. From the inverted yields of the early ’80’s to the tech stocks of the late ’90s and the low interest rates of today, diversification has allowed investors to wade through the chaos. 
Oppenheimer & Co. Inc. does not offer tax advice; you should consult with your tax advisor regarding suitability of tax-exempt investments in your portfolio. Breck Anderson’s opinions do not necessarily reflect those of Oppenheimer & Co. This article is not and is under no circumstances to be construed as an offer to sell or buy any securities. The information set forth herein has been derived from sources believed to be reliable but is not guaranteed as to accuracy and does not purport to be a complete analysis of the security, company, or industry involved. Opinions expressed herein are subject to change without notice. Additional information on the securities mentioned is available upon request.
Breck Anderson is senior director of investments for Oppenheimer & Co./Anderson Private Client Group in Leawood, Kan.
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