Summary: The Law of Unintended Consequences (Part 6) So what do we do? With interest rates at the zero-bound, and government bonds—the most stable asset class—providing yields that are below inflation, how should investors respond? How do we achieve the yields we need to live without risking the principal we need to live on? Probably the most rational response is to continue to diversify your financial holdings, and consider every asset class. That includes stocks and investment-grade bonds, but it also should include international bonds, high-yield bonds, real estate investment trusts, and master limited partnerships that have arcane tax implications. This is a time to cast as broad a net as possible to catch even a few basis points of extra yield. Be careful about extending the maturity of your portfolio, however. Interest rates are extremely low right now, but once the economy normalizes they will move back up. And it could be difficult to respond to such a move in a timely manner, as everyone who has extended their duration rushes to the exits at the same time. Interest rates can move sharply, as they did in 2005, 1994, and 1989. Don’t get freaked out when self-serving analysts trash a fundamentally sound sector, as Meredith Whitney did with municipal bonds in late 2010. That was one of the most profound misuses of notoriety I have ever seen by an investment analyst. She was rightly praised for her correct call of financial unsoundness in the largest banks in 2007, but she misused that prominence and scared millions of investors out of fundamentally sound holdings when she imprudently predicted 50-100 major municipal bankruptcies resulting in hundreds of billions in losses within a year. It didn’t happen. Keep an open mind. The forces of globalization and technology will continue to disrupt some markets and open others. New markets and asset classes can generate significant returns, but only if their growth is premised on a rational basis. A diversified approach that capitalizes on these opportunities is still the best way to generate sustainable investment income over the long haul. It’s not a free lunch. But if you do your homework, it’ll keep you fed. Douglas R. Tengdin, CFA Chief Investment Officer Follow me on Twitter @tengdin
