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The Investment Conundrum

July 22, 2020

A conundrum faced by all investments both now and over the last ten years since 2008 is how they can generate income – both for retirement income as well as an add on to portfolio returns in a diversified, non-correlated portfolio. Specifically, due to actions by the Federal Reserve (and the European Central Bank) in cutting interest rates to near zero an important component of both portfolio and income returns has been sharply reduced.


In terms of retirement income the problem is fairly obvious – reduced income to live on. However, for portfolio returns the issue is a little more subtle. Since the issue for retirement income is obvious on its face, I’ll perhaps mention that issue later. However, for now I’d like to focus on overall portfolio returns.


When looking to diversify a portfolio – not only to both enhance returns and reduce risk per Modern Portfolio Theory, one of the components that are used for this purpose is fixed income (mostly understood to be bonds – but essentially debt). Research provided to us by the Center For The Study of Securities Pricing (CRSP) at the University of Chicago Graduate School of Business has shown that the primary purpose for the inclusion of fixed income is to moderate or attempt to control risk, not to generate income. In fact, their research shows that once you go beyond five years duration (when the bond or debt matures) even with the extra yield, you are essentially taking on an equity (stock) risk but only receiving bond compensation. In other words, you’re not being adequately compensated for the level of risk being taken. Accordingly, portfolios should be managed with this thought in mind that duration should not extend beyond five years – if CRSP’s research is correct.


The problem of course is when dealing with this length of duration you are also dealing with reduced interest payments (not that extending way beyond adds all that much income these days). And, thus the conundrum: how do we get higher returns when we have a fixed income part of the portfolio which is returning negligible amounts of interest with the same allocation to equities? Now prior to 2008, we could pretty much count on a contribution to the portfolio of around 4% - 5% in interest which meant that the equity side did not have to shoulder the entire load. Thus, when looking at overall portfolio returns they were pretty decent over the long term even with a significant fixed income allocation.


When we come to today and we are looking for return or, in the case of a retiree, retirement income if a portfolio is structured to pay an income based upon gains from equities and interest that is a difficult task when fixed income is only generating from less than1% to maybe close to 2%. So, what the Fed is basically telling us is if we wish to earn more income the only real possibility is for us to assume more risk by using more equities in our portfolio allocation so we can obtain the higher long-term returns equities provide. That is the brave new world in which we live. Which of course brings us back to the conundrum of having to live with more risk (volatility and fluctuations) then we might otherwise prefer at retirement or during the accumulation phase of our lives as we become older.


The only other option is to look elsewhere other than the fixed income market for non-correlated diversification and income generation. How we address this issue, which of course, is a topic for another paper.