We may be close to getting a lesson on the wisdom of buying and holding. Just picture a period coming up where stock prices swoon and bond prices drop in value.
Stocks could drop for two reasons: First, the rise in corporate profits is starting to slow down. Notice that they are still rising, but the speed of that rise is decreasing. In some economic models, this signals an economic slowdown within six months.
Second, there has generally been a seasonal impact on stock prices -- not always, of course, but more often than not. Summer can be tough on the stock market because the market is a "voting machine" as opposed to the "weighing machine" of corporate balance sheets. If people are just hanging out on vacation, less voting takes place, so the demand and hysteria propping up stock prices dissipates temporarily and comes back in the fall. Meanwhile, companies continue to weigh the same. They don't have a weight problem except the healthy one caused by continued growth.
Bond prices could drop because interest rates, if anything, will probably rise sooner or later from their all-time lows. Just a slight rise in rates would have a big effect short term.
A typical bond fund investing in GNMA (government guaranteed mortgages) might drop 4 percent in capital value for each full percentage point increase in interest rates. This 4 percent drop is referred to as the "duration." The average maturity of the bonds in Vanguard's GNMA fund is 6.6 years. While that may be the average time for the fund's bonds to reach maturity and be replaced, we know that some are being replaced by those new higher-paying bonds right now on a daily basis. As interest rates go up, our dollars of interest income will rise. Unless we were planning to spend the bond fund money on something else, we can ignore the drop in capital value.
On a final note, the duration shown as 4 years is exactly the length of time that the 1 percentage point rise in interest will have earned enough (in four years) to offset the temporary decline in capital value.
Fortunately, the buy-and-hold investor can avoid the headache of trying to second guess the future of stock and bond markets. The brother of Charles Revson, the Revlon founder, summarized his investment philosophy by saying, "I bought a broom and I just keep sweeping it in." He was referring to his dividend income from Revlon, but on a smaller scale the same applies to anyone with some invested assets.
When confronted with uncertainty, the key is to focus on income -- not capital value. Stocks known for increasing dividends on an annual basis have increased in value by 40 percent since August 2011. Lately, however, that growth has stalled, but so what. The average dividend for this group is still roughly 2.5 percent, and we're talking about a collection of companies in a fund like Vanguard Dividend Growth that have long histories of increasing their dividend per share every year.
As for bonds, we focus on the interest income and remind ourselves that we will actually benefit from an increase in interest rates because the dollars we receive will increase. We just need to ignore the capital value decline and enjoy what will be a slow, steady increase in interest earnings. Out with the old; in with the new. The new in this case providing higher, ever-increasing income.
The problem for many investors, whether in stocks or bonds, is that they freak out when capital values drop. Some financial advisers can be part of the problem when they feel obligated to protect their clients against falling values in either stocks or bonds. A lot of futile backing and filling takes place as accounts are churned only to witness the unexpected snapback of previous falling markets.
Step one, then, is to buy into the wisdom of buying and holding. Step two is to focus on income and ignore capital value. The latter will take care of itself over the long term.
Stephen J. Butler is CEO of Pension Dynamics. Contact him at 925-956-0505 or firstname.lastname@example.org.