The Most Overlooked Problem With Asset Allocation Strategies Today.

This article will address the single most glaring problem with asset allocation strategies in America today.

I have seen many articles lately challenging the notion of buy and hold. Is it dead?! The implication being that buy and hold, as applied to asset allocation strategies and illustrated in the ever-present pie chart was, at some point, actually valid. The single flaw in the application of buy and hold as it has been marketed to the general public is this: bond funds.

How so? Consider this… Any computer generated, asset allocation program based on an investor’s response to a series of questions designed to measure their tolerance for risk produces a mix of investments. The implication is that this list will give them the highest investment return with the least amount of investment risk. The list is composed of, in general, stocks and bonds. The investor, particularly a 401k plan participant, is then led to a universe of mutual funds that will satisfy the asset allocation recommendation.

Here is the flaw. I have yet to see a computer generated, asset allocation program ask the investor for his or her view of the future direction of interest rates. Why is that important? Well here is the truth. For all of the benefits of investing in a bond fund the one that has never been present is the return of the investors’ principal. Bond funds have NEVER promised a return of principal so they are always exposed to interest rate risk. There is an inverse relationship between interest rates and bond prices. If interest rates go up, bond prices go down. Alternatively, if interest rates go down, bond prices go up.

The owner of a bond, committed to holding a bond to maturity, does not particularly care because there is the promise of the issuer that the bond holder will get his money back at maturity. It is this fact that makes the THEORY of buy and hold close to valid. It is this return OF principal that is the element of safety implied in the theory.  There is no guarantee that what you invest in a bond fund will ever be returned to you ~ and there never has been.

Bond funds, by their very design, are not suitable for inclusion in a set it and forget it asset allocation strategy.