This month marks the second anniversary of the stock market bottom reached during the bear market of 2008–09. During this downturn, the benchmark Standard & Poor’s 500 index lost 57 percent of its value from the highs of October 2007. This was the second major downturn in stocks in the past 10 years. The first came with the bursting of the technology bubble that caused a cumulative market decline of 42 percent 2000–02, according to Reuters.
As a result of this gut-wrenching market experience, many investors decided they could not afford to lose more money. Some adopted extremely conservative investment strategies, focusing on bonds and short-term investments such as certificates of deposit and Treasury bills. This shift is reflected in mutual fund flows, which show that U.S. stock funds experienced net outflows throughout all of 2009 and most of 2010, despite the significant rebound in stock prices. Meanwhile, bond funds received record inflows during the same time period, according to Morningstar.
The transition to an ultra-conservative investment strategy addresses the concern most often on investor’s minds – the risk of “losing money,” or principal risk.
But there are other risks to consider in the current market environment that can be just as detrimental in the long term. Investors should be most concerned about purchasing power risk and interest rate risk.
Purchasing power risk describes the gradual erosion of principal and income values over time due to inflation, which has averaged about 3 percent per year in the U.S. This may not seem particularly damaging from one year to the next, but over time, its impact on the buying power of a dollar is significant. This is illustrated in consumer price changes during the past 20 years. For example, in 1990, the average new home in the U.S. cost $100,000.
By 2010, new home prices averaged $181,000, an increase of 81 percent. On a smaller scale, a gallon of milk cost $2.15 in 1990, but increased to $3.88 in 2010, also an increase of more than 80 percent, according to the Consumer Price Index.
With food and energy prices rising considerably in recent months, as the world economy returns to growth, inflation risk is rising. Investors focused solely on short term, low-yielding investments are the most exposed to purchasing power risk.
Interest rate risk arises from the inverse relationship between interest rate movements and the value of bonds. For the last three decades, interest rates have been declining, meaning that investors not only received the interest income their bonds produced but also experienced appreciation in the value of their bond portfolios. However, interest rates may now be reversing this long cycle of decline and could rise from current levels.
Should interest rates rise, bond investors will face a total return headwind in the form of deteriorating bond prices that could partially or completely offset interest income. The effect is more acute the longer the maturity structure of an investor’s bond portfolio. For example, a portfolio with an average duration of 10 years can be expected to experience a decline in value of roughly 10 percent for every 1 percent rise in interest rates. Shorter-term bond portfolios will fluctuate less, and longer-term portfolios will fluctuate more.
But in the end, the investor who decided to avoid stocks for fear of losing principal may still be exposed to downside risk if they own intermediate or long-term bonds.
Given the multitude of risks that arise in changing market environments, seldom is there a single investment that addresses all concerns. The strategy that affords the best chance of mitigating investment risk is one that combines more stable investments (bonds, CDs, etc.) with investments that offer protection from inflation over time (stocks, alternative investments, etc.). Even the most conservative investor can improve the odds of achieving financial success by allocating a small portion of his portfolio to assets generally considered more risky, due to the propensity of these assets to increase in value over time. Of course, personal situations determine the appropriate level of diversification with help from professional advisers.Jeff Layman, chief investment officer of BKD Wealth Advisors in Springfield, is a chartered financial analyst with more than 20 years of experience in portfolio and investment management. He can be reached at firstname.lastname@example.org.