Look into your crystal ball and imagine this hypothetical headline 10-years from now: “Government Bonds Deliver Negative Real Rates of Returns for 10-years Straight!” “Is this even possible,” you ask? Yes, when you consider the extremely low yields bonds are offering today and the possibility of inflation over the next 10-years. Of course there is no crystal ball and no one knows what the future holds, but it is worth noting that bonds can lose purchasing power.
Now, back to the 401k dilemma–
So your employer tells you that you are eligible to participate in the company’s 401k plan and provides you with a barrage of enrollment forms and investment choices. You go home that evening to review the literature and historical returns pertaining to your company’s 401k investment options and you start picking out a few options that you think will provide the best returns over the next year, couple of years, or next 10-years. Funny thing is, these historical returns are all over the chart with no pattern whatsoever.
But, because you’re a smart person and you know that this account is “for your retirement,” you decide to base your selection on what did the best over the past 10-years or more. This insight is good, but has a major flaw: The economy moves in cycles (sometimes 10-20 years long) and you just might be picking a sector that “has” done well over its 10-year cycle and could be about to start its downward trend. One segment that is glaring us in the face right now is the bond market. Many bond funds have provided average annual ‘total’ returns of more than 6% annually over the past 10-years, and more than 7% annually over the past 5-years. As happens with bonds in a decreasing yield environment, your old bonds become worth more!
Bonds are nothing more than a promissory note issued by a company (or government body) that says, “let me borrow some money (i.e. $1,000) and I will pay you a certain percentage (i.e. 2%, or $20 every year) until I pay you back the original $1,000.” If you knew for certain that bonds in the future were only going to be paying 2% (in this example), then there would be no interest rate risk in locking up your money that is guaranteed to be paid back. But, we don’t live in that kind of world–bond yields change every day.
Continuing with the last example of a 2% yield on a government bond that matures in 10-years, what if yields on newly issued 10-year Notes started to yield 4 or 5% a few years after you bought your 2% yielding Note? You would probably be upset with the fact that you are stuck in a 2% Note and would possibly want to sell it to purchase the higher rate of return of the newly issued 5% government issued 10-year Note. If you sold your Treasury 2% Note (which still had 7-years remaining to maturity) on the market to facilitate this exchange, you could expect to get less than your original $1,000 purchase. That would mean a possible negative return on the sale of your bond. And that’s not including the effects of inflation on your shrunken dollar!
Stocks and bonds are often perceived as risky and not risky–respectively. However, armed with some knowledge about bond pricing, market rate trends, the effects of inflation, and understanding cyclical markets, together they can help you make more informed investment choices on your 401k. Basing your decisions solely on past performance can cost you a lot more than you think. That is why every disclosure on nearly every investment states the following: Past performance is not indicative of future results.
(Note: In general, the bond market is volatile, and fixed income securities carry interest rate risk. (As interest rates rise, bond prices usually fall, and vice versa. This effect is usually more pronounced for longer-term securities.) Fixed income securities also carry inflation, credit, and default risks. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.