October 26, 2023
Maintaining Equity Exposure in the Current Interest Rate Environment
In today’s interest rate environment, some investors are tempted to lock in “guaranteed” returns through fixed income instruments yielding 5% or more. However, investing solely in fixed income would be a mistake for most long-term investors. Discussed below are a few reasons why that is the case:
Higher Long-Term Returns
Over the past 90 years, the stock market has delivered average returns of ~10% per year, well above even the highest fixed income rates offered today. While stocks carry higher short-term volatility, their long-term return potential is much greater. Investing consistently in equities through low-cost index funds is likely to generate significantly higher lifetime wealth compared to parking your money in fixed income assets.
In order to preserve purchasing power within your portfolio, long-term expected returns need to at least match your rate of withdrawal plus the rate of inflation. If long-term inflation expectations are 2-3% and a sustainable portfolio withdrawal rate is 4-5%- fixed income returns of ~5% won’t provide your portfolio with inflation protection. This could result in the need to reduce spending or portfolio assets being spent down more aggressively than recommended.
Both stocks and bonds can generate income. Stocks provide dividends that change based on company earnings, while fixed income offers steady interest payments tied to a fixed rate. Given the connection to earnings, stocks provide growing dividend income over time. S&P 500 dividends have grown at around 6% annually. Reinvested dividends can turbocharge total returns. Meanwhile, bond interest can’ be immediately reinvested into the originally purchased bond, which also adds reinvestment risk. Relying solely on fixed income can mean missing out on this compounding engine.
While bonds are not typically thought of as a “risky” investment, there are risks associated with being highly concentrated in the bond market. Changes in interest rates can have drastic impacts on the value of your portfolio if you’re only invested in bonds. Given that stock and bond markets are not highly correlated and often move independently, having a mix of both should benefit your risk-adjusted return.
In summary, locking yourself into fixed income today means forfeiting higher growth and income potential from stocks. Though requiring patience and discipline, the stock market remains a key engine for building long-term wealth. Don’t make short-term decisions that compromise your future financial security. Maintain reasonable stock exposure to benefit from long-term growth. Talk to a Rockbridge Advisor today.