Quarterly Investment Foundations First Quarter 2024

Mastering The Subject

Portfolio Tradeoffs: Immediate Returns vs. Sweeter Rewards

Life is full of tradeoffs between risks and rewards. How you manage foundational decisions in your investment portfolio is certainly no exception to this rule. How much should you hold in stocks for expected growth, bonds for greater stability, and cash for near-term spending?  Getting this balance right, and sticking with it over the long run, is key to creating financial flexibility for you, your family, and the community you support.

Tradeoffs are inevitable when making foundational investment decisions to pursue growth while managing the market risk involved with investing. With interest rates as high as they are today, it can be tempting to change your investment plan for an immediate return.

History shows us, over long-time horizons, stocks have long provided the best growth. Yet, last year, savings account interest rates—the return on cash—reached as high as 5%. It is reasonable to ask whether this should impact your asset allocations. Why not take the sure bet of earning 5% on cash and avoid the volatility of stocks?

Two Types of Investment Risk: Volatility and Inflation

As an investor, you face two main types of risk. The first is volatility. Volatility is the measure of how much the value of your portfolio fluctuates over time. Low-volatility portfolios have highs and lows that don’t vary all that widely, offering more stable value over time. Assurance that your portfolio will have a relatively dependable value reduces volatility risk.

Inflation is the other risk for investors. Inflation decreases your money’s purchasing power over time. Inflation has been front and center the last few years and we likely all have direct experience with our dollars not going as far as they used to.

So, what does volatility and inflation have to do with the interest rate on your savings account? Let’s use an analogy to explain.

Sweetening The Reward

Current market conditions remind us of “the marshmallow experiment.” In the 1980’s Stanford researchers tested our desire for certainty and instant gratification by offering children a choice. They were offered their preferred treat – a pretzel or marshmallow - if they waited 15 minutes. If they wanted a treat right away, they would get their second choice. How many children were willing to wait for their favorite treat? You guessed it, two-thirds of the children couldn’t even wait 5 minutes to receive a treat – even it was their second option!

This is not unlike today’s temptation to receive a 5% interest rate on cash now or stay invested in stocks and bonds to pursue better returns. When we choose today’s interest rate, although we reduce the uncertainty of market volatility, we increase the risk of not keeping up with inflation.

History Tells Us To Be Patient

It’s no secret that US interest rates have been going up for the past two years and rates may be at relative peak. I was curious to know how stocks, bonds, and cash performed in the years following past interest rate peaks. After all, when rates have been high, investors have probably been tempted to increase their cash allocations, just like today.

Did holding more cash and avoiding stock market volatility pay off in the past? The data suggests otherwise. Given time, stocks and bonds tended to outpace inflation, and cash lagged behind.

In the figures below, I’ve compared the average annual performance of US stocks, US bonds, and One-month US Treasury Bills – a good proxy for cash – in the 3, 5, and 10 years following a federal funds rate peak. (The federal funds rate is the one you read about whenever “the Fed” announces higher or lower rates; other types of interest rates often are based on this rate.) Let’s take a look at the results.

First, I looked at a 1980 interest rate peak. Although the economy went through two recessions in the next 10 years, stocks and bonds still outperformed cash after 3, 5, and 10 years.

_{Source: Dimensional Returns Web}

The second interest rate peak was in 1995 and the outcomes were the same. Stocks and bonds outperformed cash after 3, 5, and 10 years.

_{Source: Dimensional Returns Web}

The final period I examined started in 2006, shortly before the Great Recession and including the -37% annual stock returns in 2008. Although holding cash fared better than stocks after 3 years, holding stocks would have been the better choice only two short years later, as well as after 10 years.

_{Source: Dimensional Returns Web. To calculate the geometric average annual return, data from One Month US Treasury Bills, Bloomberg US Government Bond Index, and S&P 500 Index was used. Performance was calculated for the 10-year period starting in January of 1980, 1995, and 2006 until the end of each 3, 5 and 10 year period. Interest rate peaks were determined by the historical federal funds rate. Past performance is not a guarantee for future performance.}

The stock market performance premiums here may seem modest – especially after considering the volatility. But the math is telling. I calculated the growth of $100,000 invested for 10 years in these three assets. In each case, investing in US stocks rather than holding a larger allocation in cash approximately doubled the portfolio value.

What could you do for yourself, your family, or your community with a portfolio that is double in size? As significantly, what might you not be able to do if you miss out on too much of the stock market’s expected growth?

Making choices about how to invest and spend our money comes with unavoidable trade-offs. How and when you want to reward yourself, your family, and your community can guide you in making decisions about allocating your portfolio across all economic conditions. Chances are, deferring today’s “marshmallows” will lead to sweeter returns and the impact that you want to see over your lifetime.

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Market Check-In:

- Ending the Rate Hike Cycle: At the end of 2023, the Federal Reserves signaled likely cuts to the federal funds rate are likely in 2024. Inflation has made significant progress toward reaching the Fed’s 2% target and in their view, it is possible to get to target in 2024 without causing a recession. The US economy may experience slower growth over the next year, yet unemployment is still at historic lows (3.7% in November), consumers still have spending power, and corporations seem to be managing higher costs well. This all should support economic growth.

Globally, inflation continues to recede as well. Other economies in Europe, China, and India are stabilizing or growing. Central banks around the world may also be able to ease monetary policy as inflation comes down, which would further promote economic growth.

- Stocks Hit Record Highs: The last quarter of 2023 brought record highs to US stocks. The S&P 500 returned 16.2% from October 27 to December 31 hitting several all-time highs. For the year, the S&P 500 returned 26.3%, which is well above its average annual 12.1%. US growth stocks outperformed US value stocks by a wide margin. But interestingly, value stocks beat growth in international and emerging markets for the year. While valuations of the largest US companies are unattractive, opportunities still exist to invest in US value and small companies as well as international and emerging market stocks.

- Bonds Make a Comeback: In the US, bonds returned 6.82% for the fourth quarter, likely fueled by the Fed’s projected interest rate decreases for 2024, along with slowing inflation. For 2023, US bonds returned 5.53%. Globally, bond returns were similar to the US, returning 5.72%. Inflation has come down in other major economies and this has led to an expectation that central bank’s around the world should be able to ease monetary policy in the year to come. Future returns for bonds seem promising as well. If investment grade bonds yields remain between 4-5% and interest rates continue to come down, bonds should experience price appreciation.

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_{Disclosure:
This newsletter is for informational purposes only and does not constitute investment, legal or tax advice and should not be used as a substitute for the advice of a professional legal or tax advisor.  Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. GWM is an independent investment adviser registered under the Investment Advisers Act of 1940, as amended. Registration does not imply a certain level of skill or training. More information about GWM including our investment strategies, fees, and objectives can be found in our ADV Part 2, which is available upon request.}