When Investing Play The Hands You Are Dealt

pokerIn recent weeks, I’ve written a series of articles outlining various asset-allocation models.  The models were geared toward investors nearing retirement with $1 million to invest.  Of course, concerning asset allocations, there are countless variations investors can create.  Investment objectives, time horizons, and risk tolerances will help shape allocations.  Additionally, the market environment in which we live will also play a role in shaping allocations.  As I mentioned in, “A Conservative Asset Allocation For Income-Focused Investors”:

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“Today isn’t exactly an ideal investing environment for putting together an income-producing portfolio.  Bond yields are still at historically low levels and stocks are generally not cheap.  Nevertheless, thousands of people are reaching the traditional retirement age each day.  Those people will have to play the hands they are dealt.”

Playing the hands we are dealt can be a frustrating experience.  In today’s low interest-rate environment, investors are forced to choose between taking on more risk to capture “real” yields or waiting in low-yielding instruments (cash, for example) until the interest-rate environment changes.  The recent series of asset-allocation articles approached things from a “play the hands you are dealt” perspective.  If we were in a different financial-markets environment, the allocations would have been different.  Here are two examples of how things might change in different market environments:

  1. In four of the five models presented over the past few weeks, the allocation to preferred stocks and exchange-traded debt was 10%.  Even in the most aggressive model, the allocation only increased to 15%.  Given that preferred stocks and exchange-traded debt currently offer the highest yields of the assets presented in the various models (average yields of no less than 6%), why not increase the exposure to 30%, 40%, or even 50%?  Given today’s low benchmark-interest-rate environment, a generally unattractive corporate-spreads environment, the unique type of interest-rate risk associated with preferred stocks, and the generally subordinated nature of exchange-trade debt, I think it makes sense to have lower allocations to preferreds and exchange-traded debt.  If the investing environment were different, the allocation would change.  But we have to play the hands we are dealt.
  1. Among the five asset-allocation models, the highest allocation to stocks was only 27.50%.  Some investors might be wondering why the allocation wasn’t 50% or more.  Three reasons come to mind: (1) At this time, stocks are generally not cheap.  Not cheap doesn’t inherently mean expensive.  But “not cheap” is enough of a reason to approach an equities allocation with caution.  (2) Dividends are simply too low.  Investors are constantly bombarded with commentary about how low bond yields are.  The truth about dividend yields for equities is that yields are only attractive on a relative basis.  On an absolute basis, they are not.  (3) It is true that dividend growth increases yields on cost over time.  When starting from a low dividend yield, however, retirees may discover that given their time horizons (which are not forever), the opportunity cost of forgoing much higher yields in longer duration fixed-income products is not worth it.

Just as asset allocations likely changed during your non-retirement years, so too can allocations change during your retirement years.  If preferred stocks and exchange-traded debt offered across-the-board yields of 9% as opposed to 6% to 7%, a higher allocation would be appropriate.  If corporate spreads-to-Treasuries were at recessionary levels, rather than the current slightly unattractive levels, higher allocations to non-investment grade bonds would be acceptable.  Finally, if broader-market equity indices were 30% to 50% off their 52-week highs, a higher allocation to equities would be tolerable.  But we are not in those environments today.  And investing as if we are could prove to be quite imprudent.

More from The Financial Lexicon:

The 5 Fundamentals of Building a Retirement Portfolio
Options Strategies Every Investor Should Know


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