You may have heard that you should have a mix of stocks and bonds in your portfolio to reduce risks. An economist that teaches at a top university on the West Coast tipped us off to a different approach. In this approach, you use real estate, instead of bonds, to reduce the risk of heavy swings in the stock market. Let us explain why.
How Stocks and Bonds Are Related
A rule of thumb is that the value of both stocks and bonds rises and falls together. However, there are situations where this breaks down. Under these circumstances, stocks and bonds will move in opposite directions.
When you see bonds fall but stocks rise, it is a likely indication that the economy is doing well or beginning to improve. As profits increase, stock prices usually increase. However, this leads to higher inflation. The inflation is kept in check by the Federal Reserve raising interest rates. Because bond prices are tied to interest rates, rising rates makes it more expensive for companies to borrow money. These new bonds push down the rates of existing bonds causing the bond market as a whole to go down.
When you see stocks fall but bonds rise, it is often an indication that the economy isn’t doing well. As people become worried about the economy, they will pull their money out of stocks, causing stock prices to go down. To seek a safe haven for their money, people start buying bonds – which are seen as a more stable asset. This leads to drops in the interest rates as bond prices increase. Interest rates can also be artificially lowered by the Federal Reserve – which leads to rising bond prices.
Balancing High and Low Volatility Assets
To reduce risk, general wisdom says you should have a healthy mix of stocks and bonds. Also, as the market changes, you should adjust the concentrations in this mix up or down to get the perfect balance between stocks, bonds, and the market.
This general wisdom is driven by solid reasoning. When you have high volatility (risky) assets like stocks, you need to balance them with low volatility assets. By doing this, you dampen the damage caused when the risky assets are hit hard by changes in the market. Most people choose to hold bonds as the low volatility asset.
A Better Way
There are several problems with using bonds to counter balance stocks. First, bonds have been producing low returns year after year. Bonds had their heyday in the late 1970s and early 1980s but have been in decline since.
Bonds have an inverse relationship between yield and value. In order to see higher yields from a bond, you have to pay more for the bond. Unfortunately, the higher the price of a bond, the lower the yield. This is because the investor has to pay more for the same return.
We feel there is a better way.
…the reality is that investment portfolios focused on the “Big Two Traditionals,” bonds and equities (stocks), are forcing investors to compromise – either by sacrificing return for lower volatility or enhancing return at the expense of higher risk. Real estate may offer a way out. This is why we believe real estate is increasingly being viewed, not as an alternative, but as an essential portfolio component.
“Real Estate: Alternative no more,” J.P. Morgan Asset Management
When you invest in apartments, you get higher stability like bonds. This is partly due to the longer market cycles of real estate. It is also driven by demographics which help keep housing demand high. Aside from that, apartments have had historically better returns than stocks. In other words, you get stability and higher returns making it a win-win.
You also don’t have the troublesome inverse relationship of bonds. When you increase the yields of an apartment, instead of values going down, you get a multiplying effect. So by increasing yields you also increase the value of the apartment.
If you aren’t including real estate as part of your portfolio, it may be time for a change. Contact us today to get started.
