The Allure of Treasuries
Today, I’d like to address a financial misconception that’s running rampant right now in the world of personal finance.
Financial anxiety and economic uncertainty are spiking, and investors are speculating if we are in a recession, approaching a recession, or potentially avoiding a recession.
This climate, and the overall general sentiment, have left many investors wanting to avoid risk assets like the plague. The beauty queen of the last 6 months or so has been the two-year treasury. I can’t tell you how many times I’ve heard investors tout that they’re selling risk assets and buying a two-year treasury or how they’re holding off on deploying new money into the stock market and buying a “two-year” until things “settle.”
Now, if you don’t mind, I’d like to explain why I think the two-year treasury is fool’s gold. But, first, I need to provide some background on how I personally view the financial planning process.
Now & Later
Framing matters here, so I want you to understand my perspective. When I’m viewing an investment portfolio, I’m always viewing it in light of the financial plan it’s associated with. As I often say, the investment portfolio is constructed solely to meet the objectives of the financial plan. I see investments as being in one of two categories – monies to be spent soon or monies to be spent later. My “soon” category means money one would plan to spend in the next 5 years or so, which means the “later” bucket is really reserved for one’s longer-term financial aspiration. If you think this sounds simple – perfect! I really like simple. To me, clarity is always the goal, and simplicity is the easiest path to get there.
So, now we are on the same page – some money for the here and now, and some money squirreled away for the future.
For your soon-money, yes, short-term treasuries (the two-year included) and money market accounts are a solid solution. If you were my client, I would be expecting in this environment to target my returns on soon-money at +4%. In absolute terms, this is much better than we’ve seen in the last decade. I don’t want you to miss a key point there – I said this in absolute terms. When I relate these current interest rates to current inflation rates then the picture doesn’t look as rosy. In finance, we call the net-of-inflation rate the real return. So, in current “real” terms, most of these treasury rates are actually negative.
Reality is though, we just don’t naturally think in these two-factor computations. We see the two-year north of 4% and think back to how our savings account has paid us next to nothing in the last decade and we become enamored.
It’s important that I am clear here – I really like soon-money to earn interest, so a savings account earning next to nothing is not the ideal place for my soon-money or yours for that matter. I’ll say it again, Soon-money DOES belong in short-term treasuries and high-yielding money market accounts.
Apples & Oranges
A key distinction here though, most of my conversations with folks haven’t been around their plans to “upgrade” their savings account. The murmurs that I hear are about people ping-ponging back and forth from stocks to short-term treasuries. Based on the framing I explained earlier, we can now see this is an apples-and-oranges-type issue. For me, stocks are only housed in my later-bucket, they [stocks] absolutely don’t have any business mingling with my soon-money.
Here’s where fool’s gold comes in. Fool’s gold is tantalizing at first glance until you realize that it doesn’t carry any real value. The two-year interest rate is higher because inflation is higher (for the time being). We shouldn’t be intrigued by this, rather we really should be expecting to be compensated with a higher rate to account for this inflation spike.
Now, as for the foolish few that want to swap some of your “later-funds” (e.g. stocks) with short-term solutions, you are opting for a return below the target return for your long-term money. Let me translate, when you build a financial plan, you are going to attach an assumed rate of return to your investments. I’d say for most plans these later-funds should be targeting a +7% long-term average return (Obviously there is some nuance here, but I think speaking in generalizations will minimally help provide some context, for specifics, talk to your advisor). So, again, if you are opting into a return of around 4% you are already putting yourself in the hole against your +7% target. This is like twisting your ankle in mile one of a marathon.
Market Timing, a Fool’s Errand
Stop. I know your rebuttal. You are going to tell me that things feel very unsettling right now and you are going to camp out in treasuries until things normalize and you can find a comfortable entry point back into stocks. This is simply a modified version of market timing. I personally cannot advocate for or even condone market timing, it truly is a fool’s errand. If you have a resume and track record that supports a consistent ability to exit and enter the stock market in a highly profitable manner I’d encourage you to start an investment management company because this is a very lucrative and sought-after talent. As for me, it’s not something I can do, and I can’t say I’ve ever met someone else that can either. Although, I’ve met many that have tried.
The Language of Finance
For our own education and to expand our financial vocabulary, let’s add a bit more color to this. Investors like certainty, but markets are volatile, AND investors forget that it’s this very volatility that creates the risk premium (return) they are seeking. Stocks have a high standard deviation, which means their annual returns have a high variation of outcomes around their average. Said another way, if stocks have averaged 9% annually over the last century it’s actually rare on any given year that those returns were even between 8% – 12%, but rather returns annually landed everywhere from down -30% to +30%. If we study further, we realize that this wide dispersion of outcomes gets narrower and narrower as holding periods get longer, meaning the standard deviation (volatility) actually shrinks when measured over longer periods.
So, a jittery investor that replaces a diversified stock portfolio with a short-term investing instrument like a treasury is swapping out that volatility for certainty (a fixed income or fixed interest rate). Often they are unaware of the opportunity cost this introduces, as they rarely go back and measure the return differences of what they sold out of. Note, for the month of January, stocks were up roughly 6% on the month. An investor who swapped for a fixed 4.5% and received 1/12 of that in January had a return of roughly 0.375%. You get the idea of opportunity cost here, yet stocks are not meant to be owned for a single month, so this argument is really based on the greater compounding differences we will see over time.
Next, the fixed-income investor has another risk that’s rarely discussed outside of the financial classroom and that’s reinvestment risk. Ultimately, after that term of fixed income is paid out to the investor, he or she has to redeploy those proceeds elsewhere, and there is no certainty that they will be able to reinvest at that same interest rate. I would say the odds are – based on probabilities and consensus opinion – that an investment in a two-year treasury will not reinvest those proceeds at a similar interest rate, but rather a lower interest rate. Just looking at the yield curve (interest rates across different maturities from 3 months to 30 years), and the fact that the yield curve is inverted, meaning that shorter rates are higher than long rates, tells you a forecast of that consensus opinion. Said another way, reinvestment risk is high right now.
Here’s a recap of what we’ve learned today:
(1) I should expect higher interest rates when inflation is higher – not a celebration, but rather an expectation.
(2) I need to view my investments based on their time horizon. My long-term investments deserve (require) some freedom to be volatile based on the long-term returns I expect them to deliver.
(3) You can’t compare apples and oranges; a two-year treasury and a stock serve different purposes in your portfolio and plan.
(4) I’m not good at market timing and neither are you.
(5) We’ve added to our financial vocabulary: real return, risk premium, standard deviation, opportunity cost, reinvestment risk, yield curve, and the inverted yield curve.
I’ll close us out here with one last point. So much of investing is about having a long-term plan. This spike in interest (both in rates and attention) around short-term treasuries doesn’t provide much substance for your plan past the next few years. If you study markets, and specifically implied inflation over the next 5-10 years, you’ll see those rates have retreated back to the 2% range. Basically, the market is forecasting inflation to normalize in the near future back to somewhere around 2%. If we look at where short-term treasuries were in a 2% inflation world, rates were hovering somewhere that you’d be a lot less giddy about. So, the current infatuation with short-term rates doesn’t provide much for our long-term plan. When those treasuries mature, one will find themselves reinvesting back into the rates we’ve come accustomed to over the last decade or so (psst… that’s the reinvestment risk we were talking about earlier).
Remember, great investors carry this common attribute, they are long-term thinkers who are only satiated by solutions that support long-term results. I’d suggest you adopt that same long-term perspective with your plan and your portfolio.
PWA Group Director, Partner