Asset allocation, like morals or diet, is a sphere where simple edicts often help guide better decision-making.

The goal is to rent out money at the best yield possible while still getting repaid. Pre-pandemic, my starting point was to hold a mix of global stocks, long-duration Treasuries and real estate in roughly equal amounts. This allocation assumed stocks, bonds and real estate would outperform cash over time, that bonds would provide portfolio protection in an economic downturn, and that real estate would be a decent inflation hedge.

But a crisis changes things. The Federal Reserve has cut interest rates to near zero and started purchasing more bonds and other financial assets such as exchange-traded funds — moves that may help prevent an economic depression in the U.S. but which also upend some of my basic assumptions. As a result, just like rules change in war, I am adjusting my asset allocation rules.

Today’s zero cash rates and historically rich bond valuations have the following implications:

They boost the risk of deflation to any asset allocation. Typically, cash is a bad investment because assets must, in aggregate, provide a return in excess of cash to incentivize investment. Once nominal cash rates are zero, however, slower inflation will raise real cash rates. Higher real cash rates will pull money out of risky assets, meaning cash could outperform.  

They change the characteristics of Treasury bonds. Long-term Treasuries provide a modest yield and help a portfolio in a downturn. When the economy softens, yields fall and bond prices rise. The amount that prices rise roughly equals the change in yield multiplied by the bond’s duration. But if bond yields are already close to zero, yields can’t fall that much further, so prices can’t rise that much. It’s like an insurance policy with a capped payout.

They boost the attractiveness of any asset with reliable cash flow, which helps explain the rise of the so-called FAANG technology companies. Judging whether stocks are cheap or expensive is harder because the alternatives — bonds — are also expensive, and bonds are expensive because cash rates are at zero.

Of course, certain core principles haven’t changed. You still have to save money if you want to invest. It’s as important as ever to spread your bets, since any single one is unreliable. Future cash flows depend on the broader environment, and as this pandemic has shown, the environment can shift unexpectedly. It’s still critical to follow what is important but can’t be easily predicted. Going into the pandemic, this meant tracking developments like the changing relationship between the U.S. and China, the technology revolution, the rise of populism and global warming. The virus is a new addition to this list, and it moves more quickly than the others.

The pandemic also reminds us that asset allocation is more reliable than timing markets, and that there is a downside to every investment one can own. Particularly given zero rates, one needs to imagine how all investments could be hurt. For instance, I’m worried about how the surge in people working from home will impact commercial real estate, and how newly strained state budgets will impact municipal bonds.

First « 1 2 » Next