Ep 84: Investment Allocation Update – Thinking About Your Investment Recipe

Ep 84: Investment Allocation Update – Thinking About Your Investment Recipe

Listen Now:

The Smart Take:

Having reasonable assumptions for investment returns is critically important for many reasons. These assumptions will impact your retirement plan, investment allocation, and your peace of mind.

Hear Kevin review a recent letter written to his clients about the three broad categories of investments. He’ll discuss high-level metrics on how attractive or expensive various parts of the stock and bond markets are and what to broadly expect in the years to come. Tune into the end when he discusses higher-yielding investments and how many investors are unwittingly taking more risk today than they realize.

Reminder: Investment returns are not guaranteed. There are costs to invest. Expectations discussed are just estimates and are probability-based (range-based) and are from Blackrock, Research Affiliates, Schwab and Vanguard per data available on their websites. 

Things to Consider before years end

Ep 62: Pension Lump Sums: 2021 May Be The Best Year Ever – True Wealth Design

Ep 31: Details In A Tax-Smart Retirement Distribution Plan – True Wealth Design

Ep 59: Retiree Health Insurance Part 2: Pre-Medicare – True Wealth Design

How to Get A $16,168 Tax Credit On Obamacare Even If You Are Affluent – True Wealth Design

10-year forecast from Vanguard and Schwab 

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Need help making sure your investments and retirement plan are on track? Click to schedule a free 15-minute call with one of True Wealth’s CFP® Professionals.



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The Host:

Kevin Kroskey – About – Contact

Intro:                                   Welcome to Retire Smarter with Kevin Kroskey. Find answers to your toughest questions, and get educated about the financial world. It’s time to retire smarter.

Walter Storholt:               Welcome to another edition of Retire Smarter, Walter Storholt here with Kevin Kroskey, president and wealth advisor True Wealth Design, serving you all throughout Northeast Ohio, Southwest Florida, and in the greater Pittsburgh area as well. Find us online at truewealthdesign.com.

Walter Storholt:               Kevin, what’s up with you this week?

Kevin Kroskey:                  Walter, I’m good, buddy. I think the last we spoke, we were talking a little bit of football, it’s that time of year. And you made a comment that next time we spoke, the Steelers’ record may not be so good, but just coming off a big victory against Cleveland Browns last week, I’m feeling pretty good at four and three this week.

Walter Storholt:               Yeah, how about that? Without a kicker at that.

Kevin Kroskey:                  Without a kicker, yeah. Geez. Yes. But small victory, I know we’re fighting for bottom in the division, but I’ll take it.

Walter Storholt:               Hey, never say never in the NFL, extra game this year. I mean just lots of opportunity still out there, so things may be heading in the right direction for you. So keep that terrible towel-waving, let’s say.

Kevin Kroskey:                  There you go.

Walter Storholt:               Yep.

Walter Storholt:               Well, looking forward to today’s show with you, Kevin, lots of good things to talk about. And when you sent over the notes for today’s show and I just saw the word recipe, my stomach started rumbling, but I realized we’re talking about investment recipes and not food recipes. So I’ll have to put the hunger aside for a moment.

Walter Storholt:               But before we dive into that, and I know you’re going to set the stage for us well, you also have a bit of a public service announcement for our listeners as well. You’ve been getting a lot of people reaching out now that we’re less than two months from the end of the year. And some people are acting with some urgency maybe to some things happening inside their portfolios and their financial lives.

Kevin Kroskey:                  Yeah. Literally, over the last, I don’t know, two, three weeks, we’ve had about a handful of people reach out from listening to the podcast or reading articles I’ve written over the years. We’ve done a few episodes on pension lump sums, and episode 62 was one where the title was 2021 May Be The Best Year Ever, for these. And I’m not going to go into the details, but we’re in the crunch time there where paperwork has to be filed and submitted, and if you’re going to avail yourself of that lump sum in 2021. So we’ve had a few of those in the last weeks about pensions and questions, and there’s not a whole heck of a lot of time to do proper planning, but we’ll certainly do our best to help people. So it’s good that they’re becoming aware of it.

Kevin Kroskey:                  And then also, our last episode, we talked about the tax proposal that came out for Biden Tax Plan. That certainly seems to have shifted quite a bit from when we spoke just a few weeks ago and the sausage-making continues. But nonetheless, there are always some year-end things to do from a tax planning and a tax-smart distribution plan perspective. And we’ve had a few questions relating to that as well, often in conjunction with the lump sums, what do you do, and how you tie this all together, sort of thing. We went over that in detail a couple of times over the years, but episodes 31 and 34 particularly went over that. If you’re a DIYer or just want to learn a little bit more, those are some episodes that may be good to digest. And then retiree health insurance too.

Kevin Kroskey:                  I think probably, and this isn’t surprising, but if you look at the top concerns that our clients have, particularly when we start working with them, initially is making sure that their money lasts, creating that income stream, health insurance concerns, going off the employer plan is always a big one, making the transition onto Medicare or even filling that gap before Medicare starts at 65, making sure you’re just paying your fair share of taxes but no more, and then proper investment planning. So those are a lot of the things that we talked about on the podcast because those are the key concerns that our clients tend to have over the years. And uniformly, out of the handful of inquiries, almost pleads for help I would say, we’ve received over the last few weeks, there’s been all of those in pretty much every single one.

Kevin Kroskey:                  So, I thought it would make sense to just… If you’re coming into the podcast now and listening to it, there’s definitely, I think, some good content that’s out there that addresses those pain points, specifically retiree health insurance, episode 59, Pre-Medicare, we want over in detail. And we didn’t do a specific episode on it, but there’s an article on our website from December last year, how to get a $16,168 tax credit on Obamacare even if you’re affluent, and that’s even easier in 2021 because of some of the tax changes in these stimulus plans.

Kevin Kroskey:                  So a lot of things to do in Q4 before the end of the year, pension lump sums, tax-smart, distribution planning, tax planning, health insurance, you name it, and then obviously putting it all together in the context of your financial life plan. But there’s no time like the present to get started. But the sooner you get started, the better for sure.

Walter Storholt:               Fantastic.

Walter Storholt:               Yeah, that actually brings up a good point and I don’t want to get sidetracked from the main meat of today’s episode, but I don’t think it’s something we’ve ever really talked about Kevin, and maybe we can do a fuller episode on this at some point, but how long does… Like when somebody says, “Yeah, let’s do a plan.” Or, “Let’s have a conversation.” They begin that relationship with you. I realize it’s a long-term relationship, but I don’t know, is there a ballpark average of how long you go from, we’re starting the planning process, to, okay, your plan is in place and working, and now we’re into maintenance mode? Do you even look at it under that lens?

Kevin Kroskey:                  Well, I can answer it objectively, which I always try to do quantitatively. I was in a continuing education meeting just a couple of weeks ago, and there’s an industry survey about how much time it takes in that first year to do the planning for a new client. Don’t quote me, but ballpark, it was like, I think 30 to 50 hours in total. Certainly, there’s a lot of variation that’s in there, some people are a little bit simpler, some advisors work slower than others, so on and so forth. But everybody’s a little bit different, we’re those unique snowflakes like we’ve talked about. So, some people, you can… If you’re proficient and if you’ve seen that issue several times before, and those are problems you solve all the time, you can move pretty quickly. But you also need to make sure that you’re moving at a pace and explaining in a way where the client can understand it.

Kevin Kroskey:                  The whole purpose is to not only give the advice but really give them the clarity and confidence so the client can make a more informed decision on what’s best for them. That’s really where a little bit more art than science and a little bit more bedside manner if you will than just dealing with the details that go into it.

Walter Storholt:               Like every great financial planning answer, it depends.

Kevin Kroskey:                  Yep, you got it.

Kevin Kroskey:                  Yeah. I mean, for us, usually, it’s about three to five meetings in the first year. And over time, we’ll generally get down to one to two meetings per year. But again, everybody’s different.

Walter Storholt:               That’s some helpful context at least to understanding what goes into the planning process.

Walter Storholt:               And again, if you need some help with your financial plan or want to meet with an experienced advisor on the True Wealth team, all you have to do is go to truewealthdesign.com and click on the “Are we right for you” button to schedule your 15-minute call with an experienced advisor on the team. Again, that is truewealthdesign.com. Or, call 855-TWD-PLAN.

Walter Storholt:               All right, let’s get into the meat and potatoes of today’s show. Kevin, see, you put recipe in there and I just keep making food references here.

Kevin Kroskey:                  That’s good, Walter.

Walter Storholt:               Investment allocation updates, something that you’ve talked about many times before, allocation and all related topics. Thinking about your investment recipe, what is there to update in the world of investment allocation?

Kevin Kroskey:                  Sure. Well, a couple of things, give a little context first. It’s generally I’ll write a letter, a client letter, about twice per year talking about the portfolio, how we’re positioned, changes that are being made at those times. Usually, it’s written at a time when there is an adjustment to the portfolio, really helping to educate as well as set proper expectations for investment returns. Certainly, nobody has that crystal ball, but we’ve talked about some of these expected return forecast in the past, certainly, markets change and always dealing with something new. But one of the reasons why this is critically important beyond just having a good investment recipe, which is akin to having a good investment allocation in conjunction with having good ingredients or selecting the investments is when you just think about your retirement plan.

Kevin Kroskey:                  So we have a True Wealth or Retire Smarter solution, we go through it in episode 45, but it’s really our process to go ahead and help make smart decisions and make the most out of what you have. And you start that big picture, visualizing retirement, pulling everything together, really digging into cash flows, sustainable spending, things along those lines, looking to optimize pensions, social security, and other income sources like that. But then you really have to start doing some stress testing. This is step four in our process, which we call the risk mitigator, but one of those components is really stress testing your financial plan to assess your lifestyle risk.

Kevin Kroskey:                  And really what that means to me is the risk that you’re going to have to make a change. Nobody really likes to pull back spending, but if things don’t go as well as you hope, there are different areas where maybe there’s less pain to cut back. If you have that second home or something like that, and maybe you don’t hold on to it forever, but maybe hold on until age 80 as a simple and common example I’ll often give. But you’re not going to cut back on the needs that are in your plan, so to say. So whenever you’re doing this stress testing, you need to have risk and return assumptions to go ahead and properly do it. So you have to be thinking about the investments from both a financial planning standpoint, stress testing standpoint. And then of course, just making sure that you do have a good investment recipe and you are selecting good investments to, again, try to make the most out of what you have, and then aligning that back to your plan.

Kevin Kroskey:                  So we’re not looking at investments in a vacuum, we’re really looking at in the context of everything of our life, and trying to make smarter decisions and get the most out of life and minimize our lifestyle risk, if you will.

Kevin Kroskey:                  So what I thought we’d talk about today is really just pull out some of, what I feel are, the key concepts and key information that I shared in the client letter. This is a podcast, and I wish we were in a world where you didn’t have to make these disclaimers like McDonald’s on their coffee say, “Caution, hot.” Like, okay, apparently there are people out there that don’t know that coffee’s hot, and certainly there are attorneys that will be happy to sue them if that disclaimer’s not on there. But we’re not giving advice here, this is purely educational. I’m not going to talk about specific investments or anything like that. I’m really just talking about concepts and helping people hopefully be a little bit more educated and have a little bit more appropriate expectations.

Kevin Kroskey:                  So for clients that are listening, certainly I go into more detail in the client letter, and I do talk about some of these specifics because you are clients and we are giving advice to you. So just a little bit of, unfortunately, a necessary disclaimer in today’s day and age.

Kevin Kroskey:                  When we think about your portfolio, we think about it in really three broad categories, so say preservation assets, this could be cash, lower volatility bonds, stuff that may not get a heck of a lot of return, but you’re not going to really lose your principle value, so to say. You may see a slight declining value in some bonds in a rising interest rate environment or something like that, but definitely lower volatility bonds really there to preserve your assets.

Kevin Kroskey:                  On the other hand, you can have appreciation assets, we think of these certain stocks, both domestic and foreign. You could have publicly owned real estate, or REITs, Real Estate Investment Trust, and you can also have private investments like private equity that we would put in this bucket. So a lot riskier, a lot more volatility than preservation assets. And certainly, generally speaking, you would expect a higher return because of that risk that’s involved.

Kevin Kroskey:                  And then lastly, the third category, we call these diversifying assets, some people call them alternative assets, the definitely more broad definition in this category. If you’re reading stuff online or maybe talking to different financial folks, I would say the preservation and appreciation are a little bit more well defined or accepted, but the diversifying assets, as we think of them, they’re really assets or strategies, they could be traditional assets just used maybe in a different, nontraditional manner. But they should provide a unique and positive expected return pattern, unique and positive. So you can have a unique return pattern, Walt, but you can also really not have a positive expected return.

Kevin Kroskey:                  Walt, I know you’re a sports guy and I’m sure you’re aware that you can bet on the coin flip of the super bowl.

Walter Storholt:               Right, yeah.

Kevin Kroskey:                  So definitely unique return pattern, but no positive expected return there, buddy, so hopefully, you’re not doing that.

Walter Storholt:               No, no. I don’t like the 50-50 coin flips in terms of my odds.

Kevin Kroskey:                  Yeah, okay.

Walter Storholt:               I’ll try to hedge a little better than that maybe.

Kevin Kroskey:                  Okay. Good, good. Yeah, you definitely want the odds in your favor. So some of the assets that-

Walter Storholt:               I go for the Gatorade, what color is the Gatorade going to be, because-

Kevin Kroskey:                  I didn’t even know you could do that.

Walter Storholt:               I think there is even one where you can bet on the color of the Gatorade.

Kevin Kroskey:                  Alrighty then, well, that seems to be like people could influence that, so that one could be rigged.

Walter Storholt:               It does. Yeah, you’re right.

Kevin Kroskey:                  But some of the assets that we typically would find and put in this category, higher-yielding bonds, higher yield generally means higher risk and higher volatility…another way of saying higher risk to a certain degree… preferred stock, so it’s stock, but it has preferential treatment over common stock. Oftentimes, you’ll see bank stocks in this category and other financial assets. You could also have privately owned assets, it could be private credit or privately owned bonds that just aren’t traded in the market on a day-to-day basis, as well as private real estate. So it’s still real estate, just like you may own in a public REIT. So fundamentally, it’s the same type of property by and large, but it’s not mark-to-market every day that the stock market is open. And the stock market, arguably, amplifies some of the volatility in the REITs compared to private investments.

Kevin Kroskey:                  So again, diversifying assets, we’ll talk about a little bit more, but appreciation assets and preservation assets, I think, are pretty easy to understand.

Kevin Kroskey:                  So three broad categories, Walt, so we’ll take one at a time here. Okay?

Walter Storholt:               Okay, let’s do it.

Kevin Kroskey:                  All right. So if we just go into the appreciation assets, so one of the things I put in the client letter was, and we’ve talked about this on the podcast too, what we do is review several return expectations, several forecasted return assumptions from different firms, two that I mentioned in the client letter were from Vanguard and Schwab. Vanguard, and we’ll link to these in the podcast notes, but go ahead and read them, subject to all the disclaimers that they make in their methodology as well. But Vanguard is definitely on the more pessimistic side with stocks over the next 10 years averaging about 3% to 6% on average. The higher return, the 6% is for U.S. stocks relative to the lower 3% for U.S. stocks. So that may sound a bit alarming to some, and while Vanguard is definitely more on the pessimistic side, they are by no means alone in their pessimism from the expected return forecast that we review.

Kevin Kroskey:                  On the other hand, Schwab is a bit of an outlier on the positive side. But even at that, Schwab is only expecting 6% to 7% annualized returns for large stocks per year over the next 10 years. And for Schwab, they basically expect similar returns for both domestic U.S. stocks as well as large foreign stocks. So there you have some forecast, if you will, a very broad base, but we’ll start diving down a little bit more, peel the onion if you will. So if we look at the U.S. and just think of the U.S. as the S&P 500, which everybody’s familiar with, one of the reasons why these return forecasts are lower is because of the starting price. So we’ve all enjoyed… I mean, if you’ve been an equity investor anyway, you should have received quite attractive returns over the last several years, particularly from U.S. equities. So prices have gotten higher.

Kevin Kroskey:                  Today, if you look at the valuation, basically the current price divided by, in this case, what I’ll refer to as the 12 month forward earnings or what these companies are supposed to make over the next 12 months. That’s trading it a little bit north of 21 times today. So what does that mean? Well, one way we can compare this to try to gauge if it’s reasonable or not is simply just compare it to itself over the last 20 years. So on average, over the last 20 years, the S&P 500 has traded at an evaluation of about 15 and a half or said another way, a 27% discount relative today.

Kevin Kroskey:                  So Walt, I’m curious, how does that strike you?

Walter Storholt:               I like the sound of “discount”.

Kevin Kroskey:                  Well, yeah, but the… I love you, Walt. I would give you a hug if we were in the same room right now, Walt.

Walter Storholt:               But I don’t like the sound of discount in this situation.

Kevin Kroskey:                  Right, because we’re at a non-discounted price. We’re at a high price right now and to get back to average, we would have to see stock prices come down by 27%. Said another way… And this isn’t saying… By no means take this as like, “Hey, the market’s just going to go crashing down 27%.” We don’t know, and nor do Vanguard, Schwab, or any of the other firms that do this expected return forecast, even with a good process and a good methodology. But prices are undoubtedly higher today. Whether they stay there, who knows? It’s plausible that they could largely stay intact, but not really go up anymore. And so if the companies continue to have positive earnings on average over the next 10 years, well, that valuation comes down from 21 and maybe it ends up at 15 or 16, and it’s more reasonably priced at that point, but we really haven’t had any return.

Kevin Kroskey:                  Stock markets move sideways to a large degree if you look back over the ’70s, so you somewhat had at least a similar example of this incurring in history, but it’s not that common. So you never know the path or anything like that, but nonetheless, I think there’s an elevated risk just given the price today. And it’s important, remember too, there is no good market timing mechanism. It’d be great if we just knew when to sell out of the market, go to cash or bonds, and then get back in. We’ve talked about that in the past as well, back when everything was in lockdown mode in March and April last year, when people were really thinking about cashing out and sitting on the sidelines because everything was so scary and nobody knew what was going to happen. And I’m sure most people didn’t think that things were going to bounce back, at least economically and in the investment markets, as quickly as they had.

Kevin Kroskey:                  And at that time we went through and actually looked at the evidence, both theoretical and actual, for there’s a category that Morningstar has where it’s tactical allocation. So people that are trying to do those sorts of timing moves get in and out of the market or make big allocation decisions. And the evidence, spoiler alert, is very, very poor. And what I thought was cool is that theoretically there are some good papers that were written about why it won’t work and what you can expect, and the actual evidence mirrored it very, very well. So theory meets practice, but in a negative way in that regard. So timing doesn’t work.

Kevin Kroskey:                  And also, just because something’s expensive doesn’t mean that it’s going to go down next year. In fact, if you look at know the historical returns and next one-year returns, how much does the starting price explain the next one-year returns, really close to zero. It just doesn’t. Investment markets have so much noise, and so many other factors that come into them that even though something could be in the nosebleed territory in terms of price, it could get higher in price next year. That starting price doesn’t have any explanatory power over the next year. However, if you look at a little bit longer term, just say five years, well, what you find there is that starting price is going to explain about 40% of the return variation that you’re going to have over the subsequent five years or 60 months. If you go out to seven or 10 years, that’ll actually get up even a little bit higher, maybe about 60 or 70% of the returns.

Kevin Kroskey:                  And when you think about this logically, I mean, it makes sense, price matters. You go to the car dealership or you go out shopping for some other item, certainly, there’s quality and value that’s there too. But all else being equal… which it never is, but I’ll say it anyway… all else being equal, the higher price you pay, the lower return you’re going to get. So that’s important to remember, and if I just bridge this back to the retirement plan and our Retire Smarter solution, and you think about segmenting your dollars out, most clients have, outside of the appreciation assets within the safer buckets of money, at bare minimum they have three years’ worth of their portfolio distributions within, or I would say outside of these appreciation assets. A lot of clients have five, seven, 10… Some clients have really well-funded retirement plans of more than 20 years of really their distribution needs in non-equity assets.

Kevin Kroskey:                  So if you’re thinking about putting this all together and we’re trying to make good allocation decisions, well, one of the things, one of the tools in our tool belt is, well, “Hey, we know where our client’s income is coming from if things hit the fan and we really have to pull down less risky assets outside of the appreciation bucket and just buy some more time to go ahead and let stocks rebound. And then also when you do that, some of the allocation moves that you will make, if you’re going to go ahead in favor, cheaper assets and get away from these higher-priced assets, the same sort of thing should work there too.

Kevin Kroskey:                  Again, there’s that correlation as you move out over time that, that starting price is going to explain a large degree, or at least a good part of the degree, of the return that you’re going to get over a five or seven or 10 year period. And if you needed to, you can always buy that time by spending down your non-appreciation assets first.

Kevin Kroskey:                  There was a lot that was there, let me take a pause for a moment and check-in with you, Walt. Does that make sense? Any questions? Or did I do the Charlie Brown teacher impersonation?

Walter Storholt:               No, no, they make sense. I’m tracking you so far. It’s definitely a lot of data and a lot of numbers to keep up with, but I think you’re breaking it down in a good way.

Kevin Kroskey:                  Okay.

Walter Storholt:               I’m still licking my wounds from the discount comment.

Kevin Kroskey:                  Speaking of discounts, I’ll give you another one. And I think this is interesting, which is why I’m mentioning it, but also on average over the last 20 years… Well, let me back up for a moment. Generally speaking, the U.S. market will trade at a valuation premium to the rest of the world. We’re less risky, arguably. We grow faster. We have a higher composition of sectors like technology companies compared to like Europe and what have you. And those types of companies tend to command higher-priced earning multiples. But similar to how I just compared the S&P 500 value today to itself over the last 20 years, if we compare the U.S. to foreign markets, on average over the last 20 years, the discount of foreign markets… So these are large stocks outside of the U.S., the average discount has been 13%. Today, that discount is 29%. And if you look at that a little bit further from a statistical standpoint, this level of a discount should occur less than 2.5% of the time.

Kevin Kroskey:                  So I mentioned those expected return forecasts from Vanguard and Schwab. Vanguard had a much higher expected return for foreign stocks, this is part of the reason why. It’s not saying that foreign stocks are a cheap buy. I would argue that most parts of those markets are reasonably valued. Certainly, there are parts that are more attractive and other parts that are more expensive, but in aggregate, they’re more reasonably valued, if you will. But the reason why they’re at such a big discount today is because the U.S. and the S&P 500 have done so well.

Kevin Kroskey:                  So even Schwab’s projecting similar returns, 6% to 7% range per year over the next 10 years for both domestic and foreign stocks. I’ll just mention this, but I won’t get into it, I would argue that there’s probably a little bit more of a margin of safety, if you will, in owning foreign stocks compared to the elevated price U.S. stocks, even though the U.S. is likely going to grow faster, and so on and so forth. It’s just that, that starting price for many, those U.S. assets that are within the S&P 500, are quite a high price.

Walter Storholt:               I’m tracking that, that makes sense, and good to know. There are opportunities in all of these sectors, and maybe just a few more opportunities because of that disparity.

Kevin Kroskey:                  Well, I mean it-

Walter Storholt:               Or opportunities isn’t the right word, perhaps?

Kevin Kroskey:                  No, I’m just thinking where my mind went with that question is, it’s definitely a difficult time to make a good all-weather investment portfolio. It has been for quite some time. There are certain assets that we like and like a lot more. There are certain parts of the U.S. market that are quite reasonably priced. I talked about the S&P 500, but if you look at small value stocks, they’re trading about on average where they’ve traded over the last 20 years, and that’s despite having really strong returns more recently. So, you need to look under the hood a little bit and do a little bit more thinking. I’ll just keep it a little bit higher level if you will. Our client letter goes into this some more, and if anybody is not a client, but wants to read it, you can go ahead and send us… Just go to the Contact Us page on the website, I’ll be happy to share it with you.

Kevin Kroskey:                  But nonetheless, it’s difficult today. If you go back, think of the 2000s when the tech bubble burst, and we’re approaching those nosebleed territories for valuations, it was a lot easier to go ahead and build a diversified portfolio back then, that you had a reasonable expectation that was going to do well. Interest rates were still high, maybe around 7% for bond yields. In real estate, you’re probably getting about an 8% yield back then. The stodgy value stocks that people like Warren Buffet liked, were out of favor because didn’t have a .com in the name. International stocks hadn’t done nearly as well. There were a lot more favorably priced assets back then.

Kevin Kroskey:                  And today, there are a lot more highly-priced assets all around. So it’s definitely more difficult today, I don’t think there’s any doubt about it, but that’s where my mind went. So there are still, relatively speaking, some opportunities and some probably things that you want to avoid, but it’s definitely more difficult today for sure.

Walter Storholt:               Interesting comparison back to the .com era.

Walter Storholt:               So that’s sort of the landscape for those appreciation assets, you outlined the three groups for us a few moments ago. So what about preservation assets, what’s the skinny there?

Kevin Kroskey:                  Yeah, I like these just because they’re mostly math, and it’s a lot easier, I think, to understand. But in short, the starting yield or starting rate, you can think of that, is really going to explain about 90% of the return that you’re going to get from that bond, or say from like a core higher quality, lower credit risk type bond. Everybody knows today rates are low, yields are low, ergo, expect pretty low returns from the high-quality stuff here.

Kevin Kroskey: There are two types of risks when it comes to bonds, you always need to know what risk you’re taking in any investment. But bonds are easy, I think anyway. You can take credit risk or you can take duration risk. So let me talk about duration risk, it’s a little bit easier, but duration risk is just moving out and buying longer-dated bonds. So you can think about a 15 or 30-year mortgage.

Kevin Kroskey:                  Walt, which one generally has a higher rate attached to it?

Walter Storholt:               That’d be the 30, right?

Kevin Kroskey:                  Yep, you got it. So the further you go out in time, the more interest rate risk there is overtime. Thus, the rates on longer-dated bonds or mortgages are going to be higher. You can have an inverse of that in some very unique situations, but that’s a pretty rare event, but that’s what you have there. So duration does well, longer-dated bonds do well if interest rates are about flat or if rates decline.

Kevin Kroskey:                  And I’ll just give you an example of this, but if you bought a 30-year treasury bond today, its duration is about 17 years. I won’t get into the math behind it so much about what that means, but I’ll give you a simple rule of thumb, so if interest rates were to move up by 1% over the next year, the value of that bond, that 30-year treasury bond, would come down by roughly 17% or so. So you can have pretty big losses in these longer-duration bonds if interest rates do go up. So again, they’re low right now. They’ve gone up a little bit here over the last year and a half. I know a lot of people are concerned about inflation risk and higher rates. And if you have longer-dated-

Walter Storholt:               That’s a really out of balanced seesaw, you go up 1% on one side and down 17% on the other side.

Kevin Kroskey:                  And the reverse is true.

Walter Storholt:               I’m having flashbacks to when I was a kid, Kevin, I did the very dumb thing of having all the other kids pile onto the other side of the seesaw so that I would just be hanging out way at the very top. And the idea was, I could stand on the top of the seesaw way up above the ground with all that weight on the other side, it was very stable. And then one kid said, “Jump off”, and all the other kids jumped off at the same time, and I came crashing to the ground and got a couple of stitches above the eyebrow that day. So…

Kevin Kroskey:                  Oh, geez.

Walter Storholt:               That sounds like what happens to bonds when something goes up when the interest rates go up a percent, that’s-

Kevin Kroskey:                  That’s a good concrete example, Walt. I like it. I like it a lot.

Walter Storholt:               The ground comes up fast.

Kevin Kroskey:                  And then the other risk within the category, credit risk, and people, at least people in our industry and the investment business talk about credit spreads. Really what that is, is the additional yield or the higher rate that’s charged relative to government debt on loans of lower credit quality. And this varies, I mean, you could have, like Apple, where even though there’s some credit risk there, it’s very minimal. So their bonds aren’t quite priced the same as government bonds, but the spread above government bonds for a similar duration is pretty low. If you go lower down to the credit quality, the yields will get higher, and then the risk of default or bankruptcy gets lower.

Kevin Kroskey:                  Also, I don’t think a lot of people appreciate this, but in the corporate bond world, the bonds are callable, and so if rates go down, then those corporations have the embedded option to go ahead and refinance and pay off that debt at the same time when you, the bond investor, are really enjoying those big yields that just go away once they refinance.

Walter Storholt:               What was that word you used, Kevin, callable?

Kevin Kroskey:                  Callable, yes. Yeah, thank you for interjecting there. So it just gives them an option to go ahead and call the bonds and just like how consumers will refinance their mortgage, you have these mortgage bonds that investors buy. All of us as consumers here in America that don’t have a free and clear house, so to say, we go out and get a mortgage. And those bonds, those mortgages, are packaged together and sold to investors. So as rates go down, people refinance, and then those bonds are paid off sooner. So that’s a pre-payment, but corporations have a similar option where the bonds are callable, and they will just refinance the debt, do the same thing the people and consumers do on mortgages. And then the corporation will benefit from the lower rate and the investors are left holding the bag in that regard.

Walter Storholt:               All right, very good. Thank you for the extended explanation there.

Kevin Kroskey:                  You got it.

Walter Storholt:               Is that everything to know about the preservation assets?

Kevin Kroskey:                  The one thing I would say is, so these credit spreads are tight, meaning that they’re expensive. Generally speaking, these sectors are expensive. So similar to what I said with stocks, a lot of parts of the stock market are expensive, a lot of parts of the bond market or these preservation assets are expensive too. So there’s no free lunch that’s there, so it is what it is.

Kevin Kroskey:                  And then I’ll just briefly comment on the diversifying bucket, but here, at least the way that we think of it, here’s where we would put in more credit-sensitive investments, higher-yield bonds. Higher yield sounds a heck of a lot better than saying junk bonds, but that’s another word for them, quite frankly. And there are different parts of the market, this gets a little wonky and I’m not going to go down there, but these are some things that we’re using in the portfolios for our clients today, because there are parts of these markets, even though spreads are tight in aggregate, there are parts that are more attractively priced. And there are also different sorts of ownership structures that you can use here, again whether it’s a private fund, or there’s something called an interval fund, that really in our view, better matches the investments that they own to the liquidity of the fund.

Kevin Kroskey:                  A lot of times you’ll see people owning different investments that really aren’t that liquid. And then if you own it in an open mutual fund format, and the market sell-off, some really bad things can happen where there’s just forced selling. A lot of this happens at times of distress, like the financial crisis in ’08. Even particularly in March last year, a lot of bonds really sold off quite a bit, not nearly as much as stocks, but nonetheless, they sold down a lot. But there are different things that you can do here where you could just engineer it a little bit better through the ownership structure or through even using some low-cost leverage and taking a bond and getting a little bit more expected return out of it.

Kevin Kroskey:                  There are things that you can do there, there are certain parts of the market that I think makes sense. And we have a pretty hefty allocation to these in our client portfolios right now, because we do like the risk and return relative particularly to the other two buckets that I mentioned. But this is something if you’re just a DIY or you’re probably not going to go into this category. If you are thinking about it in your DIY, or just be careful, there’s a lot of investments that are in this category that I’d say are third rate and aren’t really going to add much value there. So this is really where a lot more skill and prudence comes into planning.

Walter Storholt:               Skill and prudence, something that’s needed I think every time we join together on this Retire Smarter show, Kevin. So I appreciate your help and your guidance through talking about these things today. And again, if you want to read that letter that Kevin wrote to clients, and even if you aren’t a client, do reach out and he’d be happy to share that with you. Again, you can go to truewealthdesign.com and just use the contact page to get in touch. That’s also the place to go if you want to schedule a time to meet one-on-one with an experienced financial advisor on the True Wealth team for your 15-minute call to find out if the True Wealth team is right for you. Go to truewealthdesign.com and just look for that, “Are we right for you” button.

Walter Storholt:               Kevin, thanks for the breakdown of everything.

Walter Storholt:               Go Steelers, enjoy the beginning of fall.

Walter Storholt:               And any final thoughts to wrap up today’s show?

Kevin Kroskey:                  Watch out for that teeter-totter.

Walter Storholt:               Watch out… Don’t let all those kids… Don’t let Kevin, the jerk of the class, be on the teeter-totter when 15 other kids are on there.

Kevin Kroskey:                  Hey.

Walter Storholt:               He will tell them all to jump off. His name was actually Kevin, but [crosstalk].

Kevin Kroskey:                  Okay. Good save, Walt.

Walter Storholt:               No, it’s a true story, his name was Kevin. And my best friend growing up also named Kevin. But this was a different Kevin, this was the jerk Kevin in my life. So all the other Kevins I’ve ever met have been good, good guys.

Kevin Kroskey:                  All right. There you go.

Walter Storholt:               All right. Thank you, sir. We’ll look forward to chatting with you again in a few weeks. Got another good episode on the way, we’re going to be talking about what it means to be a “conservative investor” these days. We’ll dive into that on the next episode of Retire Smarter. Until then, thanks for listening.

Disclaimer:                        Information provided is for informational purposes only and does not constitute investment, tax, or legal advice. Information is obtained from sources that are deemed to be reliable, but their accurateness and completeness cannot be guaranteed. All performance reference is historical and not an indication of future results. Benchmark indices are hypothetical and do not include any investment fees.