It seems obvious, but one way your financial plan or investment strategy will fail is if you buy high and sell low. Simple enough, right? With interest rates at an historical low, it makes you wonder why billions of dollars are flowing out of equity portfolios and into bond portfolios.
To most investors, bonds provide a sense of safety and stability. The problem is that they are subject to market and interest-rate risk. This means that the market prices of bonds do change, a fact that almost anyone who has owned them over the past 12 to 18 months can happily tell you.
The actual math behind bond pricing can quickly become complicated, but remember that there are two primary forces at work every day in the bond market: the demand (or lack of) for bonds and the direction of interest rates. These forces, separately or together, will cause bond prices to move. When interest rates go lower, the prices of bonds go up. When investor demand for bonds increases, so does the price a seller demands to sell them.
The problem is that the converse is true as well.
Over the past few years, clients have seen their bond holdings increase in value. Interest rates have declined, and since the beginning of the economic crisis in late 2008, investor demand has been insatiable. That demand is understandable, given the unstable economy and the wild ride in the equity market. Investor sentiment has investors trying to protect their holdings from further losses, especially those around or already in their retirement years.
If bonds have just experienced an extended period of serious demand and interest rates are about as low as they can go, it may be a dangerous time to invest new money in them. Interest rates are bound to increase as an economic recovery continues, and demand may shift from bonds to equity as investors feel more confident about taking on risk. This toxic combination of rising interest rates and decreasing demand will potentially cause the value of bonds to decline.
What should an investor be doing now?
1. Get a complete and comprehensive financial plan that includes a long-term investment strategy and portfolio. Commit to that strategy. It will prevent you from making emotional decisions to sell and will keep you from chasing the assets classes that have rocketed in price and popularity.
2. Unless you are committed to buying individual bonds and holding them to maturity, don't. By buying individual bonds, you know the amount of money you will get back at maturity, as long as the entity that issued the bond does not default. Beware, however, that buying individual bonds now is a commitment on your part to accept the yield which corresponds to the purchase price of the bonds until it matures. Buying and holding a bond will result in the return of a known amount of principle, making any movement in its price subsequent to maturity irrelevant.
3. Consider taking profits from any bonds you currently hold and investing the proceeds in other asset classes that replicate income but are a better value with potential for total return over the next five to seven years.
The next five to seven years.
If an investor believes that the recovery will continue to take hold and the economy will return to its full potential sometime between now and 2015 to 2017, invest for it. Buy something low. Consider Real Estate Investment Trusts (REITs). Historically, real assets tend to appreciate in value when interest rates and inflation increase. Interest rates and inflation generally increase when the economy is doing well.
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Commercial real estate properties are depressed because of rampant speculation and overbuilding, the current economic conditions, and the financing/refinancing challenges. However, these are real buildings and a lot of them are very nice and very new. There are real, creditworthy tenants occupying them.
If you believe that the economy will recover, interest rates will go up and inflation will rise over the next five to seven years, don't load up on bonds. Instead, buy REITs. REITs, whether publicly traded or non-publicly traded, offer an opportunity to buy a real asset with upside potential as the economy strengthens, at a low price, with yields north of 5 percent.
In other words, buy low and sell high.
David B. Armstrong CFA, is a Managing Director and co-founder of Monument Wealth Management in Alexandria, Va., and he's affiliated with LPL Financial, the independent broker-dealer. He also blogs about the importance of private wealth planning, equity investing, and current economic conditions as they relate to the individual investor at "Off The Wall".
Disclosures: Investing in REITs involves special risks such as potential illiquidity and may not be suitable for all investors. There is no assurance that the investment objectives will be attained. The opinions in this material are general information only and are not intended to provide specific advice or recommendation for individual. To determine which investment is appropriate, please consult your financial advisor prior to investing. All performance references are historical and are not a guarantee of future results. Securities and financial planning offered through LPL Financial, Member FINRA/SIPC.