October 7, 2022

THE DEATH OF T.I.N.A.

by Adam J. Morgan, CFA, CMT

A child, not named Tina, gets on an escalator at the mall to go from the first floor to the second floor. As the escalator ascends, the child begins to play with a yo-yo. For a moment, allow that yo-yo to represent the investment markets; they go up and down but in the long run, they rise. The primary reason for diversifying one’s investments is to reduce the volatility of the overall investment portfolio, or, in other words, to shorten the string on the yo-yo. Reducing volatility not only allows worried investors to sleep easier at night, but it also steepens the grade of the escalator over time.

To help demonstrate this point I’ve included the table below illustrating two different hypothetical scenarios. The table shows two investment portfolios valued at $5,000,000 at time zero. Both achieve the same arithmetic mean return of 6.5% over a ten-year period, but Portfolio B is subject to a much greater degree of volatility.

In the first example, displayed in the middle third of the table, the investor doesn’t take any distributions and instead leaves the money fully invested for the duration of the ten years. Portfolio A is the clear winner by achieving a value $580,095 greater than Portfolio B simply by reducing the volatility of annual returns.

Now let’s take this same concept a step further. Let’s say that you’ve gone through the planning process with one of our financial planners, and with their help, you’ve determined that you need $100,000 per year to supplement what you’re currently receiving in social security and pension income. You decide to take an annual lump sum distribution from the portfolio on December 31st of each year to fund the following year’s living expenses. Now let’s look at how each portfolio will do given the same set of annual returns as in the previous example.

As you can see, the benefit of reducing investment volatility is amplified significantly if one happens to take a distribution in a year where the market is down. In our mock scenario, which includes annual distributions, controlling volatility yields a benefit of $742,192. When you consider that almost everyone takes distributions from their investment portfolio at some point and the investment market that is the most rewarding (the stock market) is also the most volatile in nature, it makes a lot of sense to diversify.

Ok, enough math… Who the heck is Tina and how did she die? I’m getting there, I promise.

It is a widely known truth in the investment world that bonds are less volatile than stocks. The reason for that is simple. The promised income produced by bonds tends to be more reliable than the capital appreciation investors hope to realize in a stock. So, in theory, adding bonds to an investment portfolio can bring down the total volatility of the portfolio and over time steepen the grade on your escalator. The problem is that for the past decade bonds haven’t been paying much at all. This has had the effect of forcing investors who desired healthy returns on their capital to do so by taking on more risk and overweighting equities in their portfolios.

This concept was popularized in the investment industry by an acronym known as T.I.N.A., or “There Is No Alternative” to stocks. Bonds just haven’t been a great investment in a world where the Federal Reserve was artificially keeping interest rates as low as possible. Savers trying to do the smart thing and keep a rainy day fund in a money market or savings account have had it even worse. You may not have heard many complaints, though, because the other effect of this interest rate policy is that stocks went on the longest bull market run in the history of the country. Money was cheap and the stock market ballooned. Those days are over for the time being and unfortunately, virtually every market in the investable universe has suffered losses in 2022.

But that reset has left us with an interesting opportunity. After all, many bonds are now trading at their lowest price in years. A quick Zillow search of Wake County real estate reminds us how rare it is to see anything selling at multi-year lows. The yield on the US 10 Yr Treasury Note is at the highest level in over a decade and more than seven times higher than the low of the pandemic. The US Aggregate Bond Index, a commonly used benchmark for the US bond market, now yields 4.75%, the highest level since 2009. So, if your financial plan says that you need a 6.5% annualized return to achieve your retirement goals, the increased yield from fixed income is meaningful and ultimately allows you to invest more conservatively on the equity side of the portfolio where less is needed to meet your objective. Therefore, standing here today looking forward over a long-term investment time horizon, one may be able to achieve a healthy return with less volatility, or a shorter string on the yo-yo.

Many investors are fearful of how high interest rates may need to get to adequately modulate the impact of inflation. While there is much unknown at this point, I would point to the fact that existing sales of single-family homes are down almost 26% from their peak earlier this year. That is a sign that higher interest rates have already begun to curb demand. The Federal Reserve’s own interest rate forecast known as “the Dot Plots” estimates that they will be lowering the fed funds rate in 2024. If that’s true, we may be approaching a time where interest rates and bond yields are nearing their cycle peak.

I certainly don’t mean to sound cavalier about how challenging this year has been for investors. Both stocks and bonds are down big, and it’s been difficult to stomach. You don’t have to be an expert to know that the economy and the investment markets have lost confidence. But it is worth noting the positive development that came out of all of this. Savers as well as investors who share the goal of growing their purchasing power over a long-term time horizon while investing with a risk tolerance in mind now have an alternative to simply being over-weighted stocks. T.I.N.A. is officially dead and while it hurt to watch, we’re all better off for it.—A. Morgan

Nothing contained in this post is intended to constitute legal, tax, securities or investment advice, nor an opinion concerning the appropriateness of any investment, nor a solicitation of any type and does not guarantee future results. The information contained in this post should not be acted upon without specific legal, tax and investment advice from a licensed professional. Past results are not indicative of future performance.