Well it’s that time again, time to reflect on the year that was, make resolutions for 2016, and revisit our asset allocation.

Of course, we all need to lose ten pounds. That’s the easy part. The more difficult undertaking is to thoughtfully review our long-term investment goals and take action (or stand pat) to ensure that our current asset allocation gives us the best opportunity to achieve those goals within our risk tolerance.

It’s important to recognize that each part of a diversified portfolio serves a particular purpose. For example, you may hold equities to participate in the long-run growth of the economy and as a long-term hedge against inflation. Cash may be in your portfolio to meet liquidity needs without impacting your long-term investments. In most cases, it’s obvious what role each asset class plays in your portfolio. But anecdotally, I can say that bonds are often a source of confusion.

Why hold bonds when yields are low and the Fed is widely seen as embarking on a path of rate hikes?

The answer: Your allocation to bonds can help protect you against potential equity risk in your portfolio. Investors collectively tend to have a natural bias of overemphasizing what has happened compared with what didn’t happen (but could). So it’s only natural for them to be disappointed by low bond returns, particularly during periods of strong equity performance.Blog_CarTree_01282016

But just because you don’t file an insurance claim doesn’t make it a bad choice to pay your premium—you don’t get upset that a tree didn’t fall on your car! The tendency for bonds to have low correlations with equities will make you glad you didn’t abandon them when stocks are performing poorly. In those times when equities are keeping you up at night, you’ll be glad that you didn’t abandon bonds.

But the Federal Reserve has just tightened the federal funds rate for the first time since 2006 and is likely to continue with a tightening bias for at least the near term. While this sounds scary to bond investors, the Fed is expected to act in a very gradual and deliberate manner. And while additional rate hikes should be expected, the market is forward-looking—and does a good job of pricing in expected changes in Fed policy. Also, the Fed’s influence is the greatest on the very front end of the yield curve. While further out the maturity spectrum, inflation is a much more prominent force on the level and shape of the curve. In fact, the yield on the 10-year Treasury bond is a touch lower now compared with the day before the hike.

While it’s reasonable to temper expectations about bond returns given a low-yield environment, it doesn’t change the fact that they serve as an important part of a diversified portfolio. So continue to work on those ten pounds, and continue to pay your premium.

Notes:

  • All investing is subject to risk, including the possible loss of the money you invest. Diversification does not ensure a profit or protect against a loss. There is no guarantee that any particular asset allocation or mix of funds will meet your investment objectives or provide you with a given level of income. Investments in bonds are subject to interest rate, credit, and inflation risk.
  • Past performance is no guarantee of future returns.