Are investors looking backward by fighting the last war? Not the next?

There is a phrase in the military that “generals often fight the last war,” meaning they tend to prepare for future battles based on what happened in the most recent fight instead of anticipating future risks.

Today, investors planning for the future are often no different. “What about 2022?” is often mentioned in discussions with advisors. The impact on investors that year was stark, with U.S. equities down 18% (S&P 500® Index) and U.S. Aggregate Bonds (Bloomberg U.S. Aggregate Bond Index) down 13%.  Investors had been conditioned to expect the infrequent, but possible pullback in stocks.  But bonds?  They were supposed to be the ballast to offset the risk in stocks. Historians have stated that 2022 was the worst year for bond investors since the 1700’s! And it makes investors eager never to experience that pullback pain again –ever.

What happened?

2022 was the year when the Federal Reserve turned to some of the most aggressive policy moves since the early 1980’s by raising rates.  And in all cases, the reason for the rate increase was to tame inflation. Bond returns are a function of the movement of interest rates and anticipated rate changes priced into the bond market.

As a result, 2022 saw U.S. Aggregate Bonds down 13%, Intermediate Treasury Bonds down 11% (biggest downturn since 1926) and 30-year U.S. Government bonds losing a whopping 39%*.  All of which created strong desires to avoid these outcomes – sometimes at all costs.

Just because something happened only once in the last 250 years does not mean it can’t happen again. But it’s worth looking at just how infrequent it is. Consider the graph below showing the calendar year return for the Bloomberg U.S. Aggregate Bond Index going back to 1997.

Note the magnitude of the difference for 2022. For the periods shown, the average calendar year return is 4.4% with only four years of negative returns (-0.8%, -1.5%, -2.0%, and -13.0%).  Exhibit 2 below shows a longer history back to 1976, sorted by ascending years.  Again, note the magnitude of 2022 vs. other calendar years. While the other negative return years are unfortunate, they are generally not the type of returns that torpedo long-term investing plans.

Today, too many investors are looking backward to 2022 and building portfolios to seek protection against a repeat of that year. Like military generals, being too focused on a past threat may lead them to miss future – and possibly – even greater risks to their portfolios. I see so many investment solutions being marketed that focus on trying to prevent what happened in 2022. The packaging and messaging are impressive. But is that the single risk that investors should focus on?

Consider:

• Equity valuations at or near record highs.
• Extreme concentration issues within cap-weighted indexes.
• Geopolitical events and possible impact on capital markets.
• And always the biggest: the “unknown unknowns” – things that are not knowable as of today.

What to do?

As in the past, one of the better offsets to these and other types of risk is a thoughtful, forward-looking risk-managed approach that relies on broad diversification across multiple asset classes aiming to improve the odds of helping investors meet their long-term goals. For bonds, one of the best indicators of future intermediate bond returns is the current yield of the 10-year Bond. At around 4.4% today, this is an anticipated return that is very competitive with many of the fancy products being marketed, which are often hard to understand in terms of how they work.  What we do know is that diversification works for long-term investors.

*https://www.cnbc.com/2023/01/07/2022-was-the-worst-ever-year-for-us-bonds-how-to-position-for-2023.html