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Risk Management in a Low Interest Rate World October 10, 2013
Investing is essentially about asset allocation and risk management. The objective of asset allocation is to develop an appropriate investment portfolio tailored to client specific investment objectives and the preservation and growth of capital on a real basis without assuming too much risk. The process has been exacerbated by the Federal Reserve’s monetary policy over the last five years that has pushed interest rates to their lowest levels since the 1950’s.
All investments carry a certain degree of risk, ranging from the variability of market values and income flows, to the possibility of incurring a permanent loss of capital. While risks are always present, they should be assumed only when there is a reasonable prospect of receiving a return sufficient to justify taking the risk. The future is unknowable, but investors should not be overly risk-averse, recognizing that more things can happen over the future than will happen, and the worst fears are seldom realized.
Two of the basic kinds of risk investors must consider are Systemic risk and Enterprise risk. Systemic risk involves the potential collapse of highly-levered, globally-interconnected financial markets like the depression of the 1930’s and the financial crisis of 2008-2009. After experiencing the consequences of the collapse of financial markets, investors are understandably wary about a recurrence. Systemic risk cannot be reduced by diversification, but it can be managed with a disciplined investment philosophy and an investment process focused on fundamental analysis, a long-term horizon and common sense.
Enterprise risk deals with risks associated with specific securities; including stocks, bonds, real estate, commodities, and other investment alternatives. These risks can be diversified and managed through an investment process that evaluates fundamental factors including quality, financial strength, sustainability of cash flow and, especially, valuations on an on-going basis.
Fixed Income: Bond prices had been moving higher until mid-May when Ben Bernanke gave the first indication that the Fed was on a track to begin reducing the size of its quantitative easing program that has been in effect since 2008. The outlook quickly changed and bond investors began selling, fearing that the trend in interest rates would now be higher without the Fed’s intervention in the market.
In the ensuing bond price decline, the yield on the Treasury 10-year bond moved from 1.6% in May to 3.0% in early September before falling back to the present 2.6%. This has produced negative returns for most bonds for the year-to-date and a sell-off of many interest sensitive investments. With bonds providing a low income return and vulnerable to price risk when rates rise, many investors are now looking for more attractive risk vs. return opportunities.
Equities: Stock prices have advanced steadily throughout the year. The S&P 500 Index is up 16% for the year-to-date and is only 4% below the September high. The scenario is far from rosy, but stocks have shown an impressive advance despite headwinds of higher interest rates, the slowing global economy, continued high unemployment, uncertainty for future monetary policy, gridlock in Washington and geopolitical concerns.
Despite the market advance selected stocks are attractively valued with earnings continuing to grow and an inflation rate under 2.0%. In the current investment environment equities should represent the core investment position for most investors with other suitable satellite investments added to help achieve other specific goals.
Note: We have gathered the information contained in this report from sources we believe reliable; however, we do not guarantee the accuracy or completeness of such information. You should not assume that any discussion or information contained in this market commentary serves as the receipt of or as a substitute for personalized investment advice from Whitnell & Co. No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission.