In last week’s post on investing and economic risk, I recommended a well-diversified, low-cost index fund portfolio as the best stock and bond investment. For the fixed income portion of that portfolio (which, yes, should be a permanent fixture in your long-term portfolio) I have long recommended the use of shorter-term bonds. This is true across a variety of economic conditions, and becomes especially important when inflationary concerns loom large. Let’s explore why.

In the lingo of investing, there are two primary ways to invest: stocks and bonds. A stock is a small ownership stake in a company. A bond is a loan. The bond is less risky because if the business goes bankrupt, bonds have to be paid in full before the stockholders get anything. In addition, bonds generally offer a steady stream of income.

As a general rule, it is wise to allocate a significant percentage of your portfolio to bonds to temper the risk you’re taking with your stocks. Including bonds in your portfolio reduces overall portfolio volatility.

But why shorter-term bonds in particular? After all, long-term bonds offer higher interest rates. If you’re planning to hold onto them for a long time, why not get the bond that pays the most? Because there’s a catch to stretching for that seemingly “free” extra interest.

Consider this image (click on it to view enlarged version):  

At first glance, they’re just a couple of lines intersecting. What do they mean? The blue, bottom line shows increasing risk. Bond values drop when interest rates go up. The longer the term, the greater the drop (and the greater the risk).

The gold, top line is the interest rate. Since 1964 (based on data available), one-month government bonds have averaged a 5.45% return. Five-year bonds have averaged a 7.27% return. This makes sense – five-year bonds have more risk, so they offer a higher return. By extending the bond term from one month to five years, the investor increases risk but gets an additional 1.82% return.

So far so good. But now look where the lines intersect, at about the five-year point. Past a five-year term, the blue line shows that risk continues to increase dramatically. But the gold line shows that the interest rate increases only by a paltry 0.10%!

You have to wonder, why take on the extra risk, when you can expect very little additional return? Answer: There’s really no good reason to take on extra risk unless there is a commensurate expected return. And that’s why I generally recommend short-term bonds instead of long-term bonds.

I will add one final note. There are times when you’d be glad to have long-term bonds – mainly when interest rates are falling, because long-term bonds increase in value when interest rates fall. But with interest rates relatively low these days, and with inflation likely (in my opinion) to push interest rates higher over the next few years, now seems to be a very good time to follow this rule of thumb: Reduce volatility in your stock portfolio with short-term bonds, not long-term bonds.

Turbulent economic conditions are a recurring theme here and abroad -- and it doesn’t look like these concerns will blow away anytime soon.

• Inflation Worries -- As I have described before, I think inflation is likely on its way because the Fed has been pumping new money into the economy, and the monetary base more than doubled from mid-2008 through November 2010.
• Government Debt – U.S. and global indebtedness continue to mount.
• Government Intervention -- Government interventionism in the economy is on the rise, which likely will result in higher business costs and less business efficiency.

So, yes, there are plenty of worries. But what’s an investor to do? Well, if you have a well-diversified, low-cost index fund portfolio, expertly built and properly adjusted to suit your investment time horizon and risk tolerance, simply stick with it. Nobody can predict the future, but the evidence suggests that the long-term returns of a well-diversified index fund portfolio are likely to be more closely related to the returns offered in the capital markets than to economic conditions. Don’t believe it? Read this post: Good News, Bad News and Market Returns.

If you’re not sure whether your portfolio is built to last, this may be an excellent time to seek the advice of a professional fee-only advisor, to ensure you’ve got an appropriate allocation among stocks and fixed income (bonds). And, yes, you want some of each. Even if bonds aren’t exciting, and even if they’re a little scary with inflation on the horizon, they are an important part of the portfolio. They serve to reduce portfolio volatility – because one need only look back a couple of years to see that stocks have both a downside and an upside.

I will give you one additional tip, though: Especially in inflationary times, shorter-term bonds have less risk than long-term bonds. Want to know more about it? I’ll continue the conversation on this subject next week.

Remember the “Flash Crash” from last spring, May 6, 2010, to be precise? For reasons that are still being sorted out, the Dow Jones tripped hard in an already turbulent market, plunged about 700 points and then recovered its footing within minutes. The media buzzed about it for days, but the end result for long-term investors who didn’t budge was, essentially, much ado about nothing.

But wait. On September 27, there was another disquieting little event. A recent New York Times article called it a “mini flash crash.” Shares of a venerable, 102-year-old utility company called Progress Energy lost 90 percent of their value in seconds — probably due to the human error of a misplaced decimal. Trading in the shares was halted for a few minutes. Once it was resumed, things were back to normal. Whew.

In grim tones, the article pointed out how the very nature of our trading mechanisms may mean that we’ll be seeing more of these sorts of hiccups in the future.

What should you do with this information?

Short-term investors, the type who jump in and out of the markets trying to time them, must beware of the occasional flash crash. To illustrate, short-term investors may place “stop-loss orders” under the positions in their portfolios. If the stock price drops by a certain percentage, bang: a market order is placed and the stock is sold. The idea is to limit the loss if the stock price craters. This tactic might seem smart … but if a flash crash occurs, the stock price could drop momentarily, just long enough to trigger the stop-loss and sell the position at a discount, and then go right back up. The investor has just outsmarted himself, selling his stock at a discount.

Does the flash crash worry you? Then don’t be a short-term investor. Be a long-term investor. Think about is this way. As a long-term investor, you buy at one price and you sell considerably later. You sell because you are rebalancing your portfolio, you’re revising your overall allocations because something in your own life has changed, or you’re beginning to spend your wealth. Any flash crash along the way, whether mini or major, is of no consequence to you.

Yet another reason to be a long-term investor.

Walking on salmonella-laced eggshells, wondering whether we’ve finally seen the worst of the BP oil spill, it’s clear that the world remains as risky as ever. By the time I post this blog, there will probably be yet another new headline with another unlikely risk that few of us saw coming.

As a  financial planner, I think about unlikely risks all the time. While we can only do so much to avoid a bad egg before it’s been recalled, there are reasonable steps you can take to mitigate some of the bigger “unlikely” risks. Here are some examples.

Premature Death. For most people, the chance they will die tomorrow is remote. But the consequences are too severe to ignore. Just in case, almost everyone needs a will. In addition, people who have substantial estates need expert planning to minimize possible estate taxes.

Contrary to what a life insurance salesman might tell you, not everyone needs life insurance. Nevertheless, in our comprehensive financial planning process we always examine whether the risk of death should be transferred to an insurance company by buying a life insurance policy. Life insurance most often makes sense for the younger client whose estate is not yet large enough to provide for the family if the breadwinner dies. But as the breadwinner nears retirement age, the need for life insurance as a risk management tool wanes. For this reason we usually recommend “term” life insurance policies, which expire after a certain term, and we avoid the much more expensive “whole life” policies.

Living Too Long. The flip side of premature death is outliving your money. Average life expectancy is around age 78. But if you’re a non-smoker, add six to nine years to the average. Moreover, constant medical advances are gradually extending life expectancy. Referring to the MoneyGuide Pro Annuity 2000 Mortality Table, the bottom line is that, for the average non-smoking couple, there is a 50% chance at least one spouse will live to age 91, and a 10% chance that at least one spouse will live to 101.

Health and Disability. Health insurance is a must, and disability insurance (though often expensive) should at least be considered. Depending on the situation, long-term care insurance may be appropriate too.

Cars and Trucks and Things That Go. When it comes to liability claims, every wealthy person is a potential target. Everyone who has a high net worth needs an umbrella liability insurance policy to protect their assets against potential lawsuits resulting from events like car accidents. Yes, it’s a remote possibility that you’ll get into a car accident, that it will be your fault, that someone will be seriously injured and that they will successfully sue you for millions of dollars. But it can happen, and it is a relatively cheap risk to insure against. Typically we recommend at least a million dollars in umbrella coverage, and often more.

We take our risk management analysis beyond insurance to “asset protection” strategies, legal strategies that can protect assets from lawsuits after the insurance runs out. If you’re not sure you have adequate personal risk protection, call us. We don’t sell products or prepare legal documents ourselves, but we help you provide an objective risk review, strategy recommendations and appropriate referrals.

Market Risk. Finally, some risks are far from remote, but when they occur many people are shocked anyway. Take the U.S. stock market. Since 1926, we’ve seen negative annual returns about a quarter of the time, usually in the double digits. If the stock markets weren’t subject to periodic ”head for the hills” panic runs, more people would invest, and remain invested. Supply and demand then would drive prices up and returns down. 

But, while periodic bad markets are expected, they aren’t predictable; nobody knows when they’ll begin or end. Our goal is to help investors (1) remain committed, ready to capture any upswings that may occur and (2) dampen some of the stock risk by blending stocks with bonds in well-diversified portfolios that meet the client's investment objective, bearing all of their financial goals in mind.

If you’re not sure whether your personal risks have been adequately addressed, give us a call.

 I enjoyed reading Jason Zweig's most recent column, "Holding Brokers To a Higher Standard,” in The Wall Street Journal, and I think you will too.

 Under current regulations, Registered Investment Advisor firms like Posey Capital are subject to the fiduciary standard, which means we must put clients' highest interests before our own, and we must tell you about any conflicts of interest we may have. In contrast, most brokers and insurance agents are only subject to the suitability standard. If two equally "suitable" products are available and one earns the broker a higher commission (read: may cost you more),  he or she can recommend the costlier product ... and then keep mum about the conflict of interest. Really.

Currently under hot discussion in Congress is whether all financial intermediaries -- advisors, brokers and agents alike -- should be subject to the same standards. However the debate is resolved, Posey Capital will continue to consider our clients' highest interests first. We intentionally accept no commissions for any solutions we recommend -- that's $0.00. I think it's a lot easier to simply not have any conflicts of interest than to worry about disclosing them. It's my legal obligation, but it also just makes good sense. As one individual commenting on the WSJ article observed, "It really is too simple to be this complicated."

True or false: Investing in the stock market is riskier than heading to the bank and purchasing a CD?

Actually, this is a trick question because the answer is: It depends! It depends on what you mean by “risk.” When investing over the long haul, there are two types of risk to consider.

Investment Risk

When you invest in the stock market, your holdings might go up (reward) or they might go down (risk). These gains or losses show up as real dollars that you can see in your monthly account statements, and they can be exciting or scary to watch, depending on which way they’re headed. That’s investment risk.

Hands down, it is absolutely true that you face a lot more of this type of investment risk by participating in the stock market than by purchasing CDs or similar kinds of “fixed income,” where a penny saved is highly likely to be a penny earned. For better or worse, your CD’s monthly statement will pretty much look the same every month.

On the other hand, by investing in the stock market, you are expected (although not guaranteed) to earn more real return than from purchasing fixed income such as CDs — if you stay the course and stoically accept the required investment risk. Historically, that equity risk premium has been around 5 percent per year.

Compare this to inflation, which has been around 3 percent per year … and which brings me to my next point.

Inflation Risk

While stocks are more vulnerable to investment risk, fixed income is far more vulnerable to inflation risk, or the risk that the purchasing power of your money will decrease over time in the face of inflation.

Think of it like a leaky bucket, in which the drops of water being added (such as CD interest) aren’t enough to compensate for the hole in the bottom (inflation). Or, for a real example of how inflation impacts your spending power, consider the price of postage. It cost you $0.06 in 1970 versus today’s $0.44 to deliver the same letter.

Inflation risk can wreak havoc on your wealth. There are periods, sometimes lengthy and severe, during which purchasing power is so diminished by inflation that “safe” investments actually yield significant negative real returns when measured with their ability to keep pace with inflation. In addition, inflation risk is insidious, because the damage doesn’t show up us obviously negative numbers in your monthly returns statements. Dimensional Fund Advisors’ CEO David Booth provides a fascinating presentation on the subject, which I recommend you view for more details and specific data-driven illustrations on the subject.

Let’s return to our true/false question: Are stocks “riskier” than CDs? As is so often the case, the truth seems to lie between the two extremes. The best way to manage risk is by building a well-diversified portfolio that controls for inflation risk with equities and dampens investment risk with fixed income.

In a seven-minute video, David Booth, the chairman of Dimensional Fund Advisors, explains why inflation makes US Treasury bills riskier for the long-term investor than stocks.