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That is clearly no longer the case, and it has serious implications for traditional asset allocation models. Some might argue that if you hold the bonds to maturity then price risk is only a temporary problem, but that's a dangerous half-truth. Today's investors frequently hold their bonds in diversified pools of mutual funds and ETF's, giving up any ability ride out the downturn and hold a specific bond to maturity.

The losses can become permanent. Whether you think interest rates will rise or not is irrelevant. The point is the downside risk of loss is high in what many investors consider to be their safest investments, and they are getting paid paltry returns to accept that risk. The risk vs.

It makes no sense. That depends on many factors including your investment goals , time horizon, specific portfolio composition duration, quality, etc. Of course, I don't have a crystal ball and have no clue when and to what degree interest rates will rise. I just know it will eventually happen, and the downside risk when it occurs doesn't justify the return being offered to accept that risk. The only questions remaining are timing and severity — both are complete unknowns.

What we do know is eventually, investors will demand greater return to accept the risk associated with lending their money. As nations become increasingly in debt, how many more short-term fiscal manipulations can be applied to keep interest rates artificially low? And yes, I'm fully aware that naysayers have been saying the same about Japan for a very long time and been completely wrong. I'm the first to admit this analysis says absolutely nothing about timing — a critically important fact.

Would you lend to the U. Government for 5 years for an 88 basis point return?

Nobody in their right minds should risk substantial downside losses for a maximum potential upside gain close to zero or worse net of inflation. I'm not in the investment forecasting business. I rarely write posts like this because forecasting financial markets is a fools game that has no place in sound investing. The future is unknowable and anybody who plays in forecasting the market is destined for humility.

What I'm sharing with you here isn't a forecast. There are rare times when valuations in specific markets reach such absurd levels that the risk vs. It was based entirely on business common sense and required no forecast. I want to be clear that I had no idea when the actual market tops would occur in the past or how they would come unwound, and the same is true with the bond bubble today.

Of course, we found out after that fact there was massive lending fraud. I also saw the real estate investment deals my financial coaching clients were examining. Valuations got so absurd near the top in that deals were transacting where it was literally impossible to make money from operating the property. Even if you had zero vacancy, no maintenance costs, no turnover costs, and none of your expenses ever increased, the property would still be cash flow negative.

The only possible way to profit from ownership was if a greater fool came along and paid an even stupider price for the property than was being asked at the time. It was a recipe for disaster. It doesn't take a rocket scientist to see the risk to real estate when the absolute lowest credit quality buyers are already fully invested in the market, and prices are so high they make no economic sense using absurdly optimistic assumptions.

What I didn't know was when or how much real estate would decline. The fact that selling all my real estate by the end of was nearly perfect timing was actually total luck. The real estate markets could have remained overvalued for years and gone to even more unfathomable extremes. I didn't know where and when the bubble would end. I just knew it was a bubble and the valuations made no sense. I sold my properties for more than two times as much as I was willing to pay for them, paid the taxes on the gains, and never looked back. Similarly, when the stock market bubbled in the late 's, I eliminated all of my traditional equity allocation in my portfolio, and sold my investment management company by the end of In this case my timing was way too early.

The markets continued to rise relentlessly, going from ridiculously overvalued to unbelievably overvalued before the final top in Again, it's just business common sense that when the entire NASDAQ index is selling for more than times earnings at the top, it can only end badly. It was just a question of when — not if. The valuation was unsupportable. It was business common sense. Everybody and their mother wanted to get rich in stocks back then.

Every coaching client wanted hot stock tips. He was blind to the message and lost most of his net worth in the downturn that followed. The psychology was absolutely frothy, and amazingly, it continued that way for years, creating the most overvalued stock market in U. I had no idea on the timing for the bubble burst, and in this case, I was way too early. Ultimately, the position was vindicated by the massive decline that followed, but I want to be clear that this type of analysis tells you absolutely nothing about timing — only ultimate outcomes.

And that brings us to today's bubble du jour — the bond market.

Podcast 166: Ken Lin of Credit Karma

I have absolutely no clue when the final top will occur. It could finish this week or continue on its merry death march for a few more years. Bank of America provided similar numbers, showing U. According to Reuters, even the biggest names in bond management PIMCO, Loomis, DoubleLine are making business moves into equity funds and diversifying their businesses. The writing is on the wall. Bottom line is valuations make no sense in the interest rate market.

Of course not! It's insane. Completely insane. Yet, fortunes are traded every day on that exact premise and people have major chunks of their retirement savings invested accordingly. Hopefully you will be wiser. Caveat emptor. Only you can decide what the appropriate investment strategy is for your portfolio. This is an educational article and does not offer personal investment advice. With that disclosure in place, you probably want to know what I'm doing with my own money given this information.

The answer is I will do the same thing I did before the stock market bubble burst and the real estate bubble burst: I exit the market. I'm willing to accept the risk of leaving the last few breadcrumbs on the table and being temporarily wrong for years in exchange for giving up the risk of being invested during the highest risk periods when mathematical expectation is unfavorable. Others may view their investment situation differently and be equally correct. For example, U. Treasury bonds are one of the few asset classes that have maintained low to negative correlation with equities in recent years, providing a valuable portfolio diversifier that has substantially reduced volatility in the past.

This is the math that governs how money compounds and it's inviolable. Mathematical expectation trumps all other investment considerations, and bonds show limited upside potential with strong downside risk. Knowledge is your only defense. Yes, it is critically important when investing to know the limits to your knowledge and how to work with those lmiitations. The future is forever unknowable. One must accept risk into the future given this limitation. It is an amazing process. Great article and thank you for sharing, Todd!

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Of course everyone else will look to do the same. Equity markets have been volatile and the highest demographic people with money are baby boomers. They have reason to be concerned about their retirement picture, especially ones without a pension. Strong, highly rated corp.

So, bond funds and ETFs would likely be the alternative and there is no principal protection. Given the data, we have seen a 30 year decline in interest rates.

May 17, 2005

So, yes it is a matter of when — not if. Thank you again for posting this timely piece. All the best, save4urfuture. Yes, it is amazing to watch these rolling bubbles created by government manipulation in the markets. They keep messing up the normal economic signals that would prevent such occurrences.

Podcast Ken Lin of Credit Karma - Lend Academy

Thanks for the excellent, timely post Todd. I appreciate your analysis, and your sharing of valuable experiences from and I think that would make me loathe to ever completely sell out of a given asset class. And there is an important follow-up question that anybody contemplating action will have to face: where to put the money, if not in bonds? Many of the major asset classes are experiencing price inflation now.