By James M Dahle, MD, Emergency Physician, WCI Founder
I got this question by email.
Q. “What do you think of this reasoning by Ray Dalio? Are bonds a ridiculous investment at current conditions?”
Let me summarize Ray's argument in case you're not aware of it:
“Bond markets offer ridiculously low yields. Real yields of reserve currency sovereign bonds are negative and the lowest ever. Real yields of cash are even worse, though not as negative as they were in the 1930-45 and 1915-20 great monetization periods. Nominal bond yields are just off the lowest-ever made a couple of weeks ago. These extremely low or nonexistent yields do not meet these asset holders’ funding needs. For example, pension funds, insurance companies, sovereign wealth funds, and savings accounts cannot meet their financial needs with these investments so holding bonds assures their failure to meet their obligations. At the same time, while there is some room for diversification benefit, because of limitations of how low interest rates can go, bond prices are close to their upper limits in price, which makes being short them a relatively low-risk bet….The economics of investing in bonds (and most financial assets) has become stupid. Think about it. The purpose of investing is to have money in a storehold of wealth that you can convert into buying power at a later date. When one invests one gives a lump-sum payment for payments in the future. Let’s look at what that deal now looks like. If I give $100 today how many years do I have to wait to get my $100 back and then start collecting the reward on top of what I gave? In US, European, Japanese, and Chinese bonds an investor has to wait roughly 42 years, 450 years, 150 years, and 25 years respectively to get one’s money back and then one gets low or nil nominal returns. However, because you are trying to store buying power you have to take into consideration inflation. In the US you have to wait over 500 years, and you will never get your buying power back in Europe or Japan. In fact, if you buy bonds in these countries now you will be guaranteed to have a lot less buying power in the future. Rather than get paid less than inflation why not instead buy stuff—any stuff—that will equal inflation or better?”
There has been a lot of hand-wringing over low interest rates the last decade or so. It is not particularly new, but it seems to have gotten worse since the pandemic-related stimulus packages have occurred and made people think a little more about inflation as they see the government printing money. The funny thing about it is that most of the people doing the hand-wringing only make vague allusions to what an investor is supposed to do about these low interest rates. If you get into a long-involved conversation with them, you find out that all they've really done is made some token change to their portfolio. For instance, I can't tell you how many arguments I've gotten into with people about cryptocurrency where they explain how it is the best thing since sliced bread and then at the end admit they've only got 1% of their portfolio in it. At that point, it's clear to me that deep down inside we don't actually disagree very much, only about 1%. Heck, my disagreement with Peter Kim is 60 times that large! (My portfolio is 20% real estate and his is 80%).
Today, I want to actually give you some specific advice about what to do as an investor in our low-interest-rate environment. Like a diversified portfolio, some of what I say today will be proven to be the wrong thing to do, but only when judged retrospectively by the results. However, as Larry Swedroe frequently says, don't confuse strategy with outcome. When looked at prospectively, there are many potential future outcomes that your strategy must take into account. Retrospectively, only one thing happened. Prospectively, putting all your money into Bitcoin for the next decade is stupid. Retrospectively, putting all your money into Bitcoin for the last decade is brilliant. It's important to understand the difference and not fall into the common behavioral bias known as hindsight bias. Hindsight bias is the tendency people have to view events as being more predictable than they really are.
All right here we go.
Sensible Feels Silly
The most tragic part of a low-interest-rate environment is that it makes otherwise sensible financial advice look silly, and it can look silly for a long time. Low interest rates, especially when combined with a new technology or development (oceangoing ships, railroads, canals, mutual funds, SPACs, radio, the internet, CDOs, cryptocurrency), often leads to periods of substantial asset overvaluation (at best) or even bubbles (at worst). While the bubble is building, your grandfather's advice seems kind of stupid. But your grandfather has lived through both booms and busts and he has a long memory. Grandfatherly advice might include:
- Save some money for a rainy day
- Pay off your debts
- Make sure your cash is insured by the FDIC
- The return of your principal matters more than the return on your principal
- Never have less than 25% of your portfolio in bonds
- Keep your bonds short-term and high-quality
- Make a big down payment
- Don't invest on margin
- Broadly diversify
- Avoid new fancy investments
It all seems like sensible advice, right? But it has all been wrong for the last 5 or even 10 years. Over the last few years, violating every one of those investing rules has resulted in more wealth.
However, grandpa will be proven right in the end. Every boom is followed by a bust. The wisdom of the ages is exactly that. Beware of throwing out the lessons of history. The main problem with investors as a whole is that their memories are too short.
Follow Your Plan
Long-term readers will not be surprised to hear me recommend that you get a written investing plan and then actually follow it. Midway through residency, Katie and I drew up a long-term investing plan. Then we followed it for a decade. Seven years later we were millionaires. 10 years later we were multimillionaires. A few more years and we were financially independent. It didn't happen overnight. It wasn't guaranteed to happen. But it was VERY likely that it would happen eventually. The thing about a good long-term plan is that it actually takes periods of time like this one into account. As a Boglehead said recently in reference to Ray Dalio's rant:
“I would not be an enthusiast for changing around a long-term plan every time one asset or another becomes unattractive. Long-term plans assume that happens all the time.”
The point of a “know-nothing”, fixed asset allocation, strategic asset allocation investing plan is that you don't know the future. There are times when interest rates will go up and interest rates will go down. Stocks, bonds, real estate, commodities, and everything else will have good times and bad. But over the long run, no matter what economic outcomes occur, your plan will carry you to your financial goals. If your crystal ball is cloudy, like mine, you need a plan that doesn't require you to predict the future in order to be successful. That means adequately funding a plan with broad diversification and periodic rebalancing back to the pre-set percentages.
The main thing that people don't get who engage in this type of thinking (that cash and bonds suck at times of low interest rates) is that everything sucks. What do I mean by that? I mean that expected returns for ALL asset classes goes down when interest rates go down.
The best predictor of future nominal cash and bond returns is the current yield to maturity. That part is obvious and everybody seems to get that. However, when interest rates are low (making cash and bonds seem less attractive), people bid up the value of other assets such as stocks, real estate, gold, and cryptocurrency. The process, while not perfectly efficient, is efficient enough that you should probably still act as though it is perfectly efficient. Interest rates go down and stock Price to Earnings (P/E) ratios go up. As P/E ratios go up, expected returns on stocks go down. The same thing happens with real estate. As interest rates go down, people are willing to spend more on real estate since financing it costs less. As yields go down, alternative assets like gold and Bitcoin become more attractive, so their price gets bid up.
My point is that it isn't just bonds that suck right now. Everything sucks. If you're expecting that your portfolio returns from 2021-2030 are going to be equal to what you experienced from 2011-2020, you are very likely to be disappointed. But that doesn't mean you should invest any differently.
Adjust for Inflation
A lot of people look back with great fondness and nostalgia for the early 1980s, when you could buy a 10-year treasury bond yielding 10%. What they forget, however, is that inflation that year was over 13%. In effect, bond yields were -3% real, and that's before taxes. The top tax bracket in 1980 was 70%. Once you paid taxes on that 10% yield, it was really a 3% yield and your after-tax, after-inflation return was -10%. As I write this, a 10-year treasury yields 1.62% and the top tax bracket is 37%, leaving an after-tax yield of 1.62% * (1-37%) = 1.02%. Inflation is at 1.68%, leaving an after-tax, after-inflation return of -0.66%. While that is no doubt disappointing, it is dramatically better than what you were getting from the same investment in 1980. Be careful what you wish for. Higher interest rates often co-exist with high inflation rates.
Rates Don't Have to Go Up
Lots of people also seem convinced that interest rates have to go up. Unfortunately, that's not true either. The classic example these days is Japan. Here's a chart of the Bank of Japan's key short-term interest rate over the last few decades.
As you can see, rates have been under 2% for over 25 years. If you, as a Japanese investor, had fled Japanese bonds for Japanese stocks due to low interest rates in 1989, you may not have been happy with the return on your stocks. The Nikkei 225 index peaked on 29 December 1989 at 38,957. As I write this post, 32 years later, it is at 29,914. Just 5 years ago it was under 17,000. Just because bond returns are crummy does not mean stock returns will be higher. In fact, both may be lousy for long periods of time.
Scared of Inflation? You Should Be!
Lots of investors are worried about inflation these days. Even though inflation is still under 2% (the Fed's target), you should still be worried about inflation. However, this should not be a NEW worry for you. Of the four “deep risks” to your portfolio (inflation, deflation, confiscation, and devastation), inflation is by far the most common. My own portfolio has been set up to combat inflation for the last 15 years. That inflation hasn't shown up yet, but it probably will at some point in my investing career. How did I set my portfolio up to combat inflation? Well, let's go through my portfolio step by step.
- 60% Stocks – When inflation rises, companies can charge more for their products and services and so the value of the company over the long run tends to keep up with inflation.
- 20% Real Estate – As inflation rises, landlords can charge more rent. Their properties become more valuable and their income goes up. Even better, most real estate involves some leverage, usually at a fixed rate. If there is anything that does well in inflationary times, it's being a debtor with fixed interest rate debt. Nothing quite like borrowing $500K and paying back $200K over a long period of time.
- 20% Bonds – Bonds do notoriously poorly during inflationary times. But even my bond portfolio is set up to do as well as it can against inflation. Half of it is in TIPS, inflation-indexed bonds. When unexpected inflation hits, they do particularly well. With the rest of the bond portfolio, I keep durations short so that the rising interest rates that generally accompany inflation won't hurt it too bad. For a long time, my only nominal bond holding was the TSP G fund, whose principal doesn't go down at all when interest rates rise.
The bottom line is that my portfolio is already set up to combat inflation. I don't need to make adjustments just in case it happens.
Take on More Risk or Less Risk?
The insightful investor will be left with a dilemma at this point. Should the investor take on more risk or less risk? With yields low, valuations high, and expected future returns low, an investor may feel a need to take on more risk to get the higher returns the investing plan needs to reach its goals. On the other hand, with expected returns being lower, the investor finds investing at all to be less attractive. Perhaps now the guaranteed return of paying off debt looks better, despite low interest rates. Or maybe spending a little more instead of saving looks better. Yet in order to reach goals, the investor should now be saving more than ever because future returns are likely to be worse. Cash yields nothing, but you want to have some dry powder to buy when asset prices finally do fall. Interest rates are low making leverage more attractive, but the risk of falling asset prices increases the risk of leveraging them up! What a dilemma! But it's really not all that different from the dilemma at the other end of the economic cycle. When interest rates are high, paying off debt looks better but so does investing.
Now you can see the wisdom of having a written investing plan to follow. You follow it when interest rates are high. You follow it when interest rates are low. You follow it during booms and busts. Slowly but surely, year by year, you get closer to achieving your goals.
What About Speculative Assets?
When the expected returns on traditional investments like stocks and bonds are low, investors naturally start looking elsewhere. As Dalio says, “Why not buy stuff—any stuff, that will equal inflation or better?”
Maybe Ray is saying store more food at home, or buy some appliances that you can later pawn on eBay. Or maybe bullets, booze, and cigarettes. Or perhaps art or wine. Even with “stuff” that people will use, there is a cost to storing, protecting, and insuring it.
These days the speculative assets of choice seem to be precious metals and cryptocurrency. A decade or two ago the assets of choice were commodity futures, real estate, and petrochemicals. Unfortunately, as mentioned above, the price of these assets also tends to be bid up when interest rates are low, lowering future returns. If you want to dedicate some of your portfolio to these assets, I recommend you limit the amount to 5-10% and stick with it long-term. Over the long run, gold tends to keep up with inflation, but it tends to do so in quick bursts separated by decades. Commodities and empty land tend to perform similarly and cryptocurrencies haven't been around long enough to really know. I suspect most investors in all of these assets buy high and sell low most of the time. Try to avoid doing that, even if it is with just 5% of your portfolio. Keep the majority of your portfolio in productive and interest-bearing investments such as stocks, bonds, and income-producing real estate.
What About Going Overseas?
Lots of people are worried about all the dollar printing going on. While it's okay to worry a little, it's important to remember that there are both inflationary and deflationary pressures going on at any given time. If millions of people are getting laid off at the same time a bunch of dollars are being printed, it may balance out just fine. Fleeing to foreign stocks and bonds assumes that similar pressures don't exist there. In fact, they probably do. Look at these 10-year government bond yields from around the world:
If anything, the average is worse than US bond yields. It's even negative in many European countries. That's right, people are PAYING to invest in bonds. If ever there were an argument for cash, that would be it! But my point is that the same pressure on US stocks and bonds from low interest rates is also taking place overseas. Now, if I had to bet whether US or international stocks are going to outperform over the next 10 years, I'd put my money on the international stocks. Since I don't have to win that bet to reach my goals, I'm going to do exactly the same thing from 2021-2030 that I did from 2011-2020 and keep 1/3 of my stocks overseas and 2/3 in the US. What a wonderful thing a written investing plan does! I only had to make a decision once and now I don't have to react every time interest rates change, one asset seems more attractive than another, Elon Musk tweets, or Ray Dalio gives an interview! Now I can concentrate on what really matters in my life—staying healthy, supporting my family, taking care of my patients, and helping doctors stop doing dumb stuff with their money.
In conclusion, I don't like low interest rates any more than you do. While it's hard to get excited about paying off 2-4% debt and earning 0.6% on your savings account, once you realize the alternative might be losing 30% on your stocks, 50% on your leveraged real estate, and 90% on your cryptocurrency, those measly returns don't seem so bad anymore.
What do you think? Have you changed your personal financial or investing plan due to low interest rates? In what way? Comment below!