Bloodied Broken Models

• So-called “low risk” investment models are losing as much, and could lose even more, than high risk models.
• Most models rely on bonds for protection. That’s why they no longer work: bonds are not protecting.
• New and better models protect with cash and TIPS. The Nobel Prize winning Capital Asset Pricing Model demonstrates why risk is best controlled with cash.

Several years ago, I wrote Broken Models that advises the integration of age into model portfolios. The following article deals with risk control and warns that bonds are now risky, so they are not a good risk control. Recent bond performance has bloodied broken models.

Most investment consultants and money managers use models. They “customize to your needs” by matching you up to an off-the-shelf model. The model in the middle, between conservative and aggressive, is the famous 60/40 you hear about all the time.

Much has been written lately about the problem with the ubiquitous 60/40 stock/bond model, in articles like the following:

• The Problem With The 60/40 Portfolio - Forbes
• Traditional 60/40 portfolio has actually reached its expiration ...CNBC
• Is the 60/40 Dead? - Goldman Sachs

The problem is that the 40% in bonds is not safe. So far this year that concern has been confirmed. Bonds have suffered losses similar to stocks. Consequently, all models have disappointed because they all use bonds to defend, as shown in the following.

Interest rates are going up and they will keep going up for a long time. As a result, “low risk” models will suffer similar, or even worse, losses than high risk. And near-dated target date funds (TDFs) will suffer similar or worse losses than long-dated.

That’s not supposed to happen. “Safe” models are supposed to protect against losses. The old models don’t work.

The damage to target date funds so far

Target date funds are not safe because bonds are not safe

 The following graph shows the performances of TDFs. The “Industry” is the S&P target date index, a composite of all TDF mutual funds. TSP is the Federal Thrift Savings Plan, the largest savings plan in the world, at $800 billion.

The Industry defends with bonds . By contrast, the TSP protects with a government guaranteed G fund, similar to Treasury Bills. Consequently Industry 2020 funds are 85% risky at the target date when you classify bonds as risky, versus 95% at long dates, so about the same. By contrast, the 2020 TSP fund is only 30% risky.

A first

“Low risk” funds are not supposed to lose more than high risk in a down stock market, and they never have before. 2022 could be the first year ever when bonds do not protect in a falling stock market. As shown in the following graph, bonds have never failed to protect before in a down stock market.

Going forward

To fight inflation, the Federal Reserve is raising interest rates and tapering its bond buying that maintains ZIRP: Zero Interest Rate Policy. Some say that the Fed will react as it did in 2013’s “Taper Tantrum.” Tapering in 2013 caused the stock market to fall, so the Fed reversed course and reverted back to ZIRP.

But unlike 2013, inflation is raging now, so reverting to ZIRP will fuel the inflation fire that the Fed has said it will extinguish. Wall Street sees the Fed opting for ZIRP, allowing inflation to escalate, but ZIRP will become increasingly expensive as inflation rises because investors do not like to lose in real terms (earn less than inflation).

Many see interest rates rising to historical averages of 3% above inflation. In an 8.5% inflation environment, that’s 11.5% yield on 10 year bonds.

 Going forward, interest rates are likely to continue to increase for many years.

Sequence of Return Risk

It is well documented that investment losses suffered by people near retirement can ruin the rest of their lives. Accordingly, TDFs are supposed to protect those near retirement, in 2020 funds, but they will not protect going forward because interest rates will continue to increase for a long time, crashing bond prices.

The disappointment is just beginning. Investment models and TDFs are built on a foundation that is crumbling because bonds are not protecting. Investors need to embrace the new reality, especially the 78 million baby boomers who are in the Risk Zone spanning the five years before and after retirement.

Protect now

The “new” protection is the “old” protection -- Cash and TIPS (Treasury Inflation Protected Securities). But you won’t get this protection in most TDFs nor most model portfolios. You’ll need to do it yourself.

Dr William F. Sharpe won a Nobel Prize for his Capital Asset Pricing Model that demonstrates why risk is best controlled with good old fashioned cash. Advisors have shied away from using this model because clients don’t want to pay an advisory fee for cash 

For guidance on this move to protect yourself please visit Age Sage  where for a small fee you can see models that defend with cash and TIPS based on your age and risk preference. It’s affordable education that you won’t find elsewhere. These models use my patented Safe Landing Glide Path that emphasizes protection in the Risk Zone.

Conclusion

The warnings about the risk in bonds are being substantiated. Bonds are losing money and will continue to lose for years.

The challenge now is replacing bonds as a “safe” asset. In this inflationary environment, “safe” should also protect against inflation. Treasury Inflation-Protected Securities (TIPS) can help. Other inflation protection comes with uncertainty, like precious metals and commodities, but these are worthy of consideration as well.

Articles that warn about problems with 60/40 suggest a “40” that is not bonds. They’re usually “selling” something, like annuities.

 Regarding target date funds, my “ask” is protecting beneficiaries near retirement. My patented Safe Landing Glide Path^® provides this protection. It’s similar to TSP, except it’s U-shaped, re-risking in retirement. That’s what I’m selling.

All model portfolios -- not just 60/40 -- are topsy-turvy. “Safe” models are not protecting. But there’s education to help you protect at Age Sage. There is a small charge for this education.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.