CHAPTER TWELVE

Summary

As I traipse around the country speaking to investing groups, or just stay in my cage writing my articles, I’m often accused of “disempowering “ people because I refuse to give any credence to anyone’s hope of beating the market. The knowledge that I don’t need to know anything is an incredibly profound form of knowledge. Personally, I think it’s the ultimate form of empowerment. You can’t tune out the massive industry of investment prediction unless you want to: otherwise, you’ll never have the fortitude to stop listening. But if you can plug your ears to every attempt (by anyone) to predict what the markets will do, you will out-perform nearly every other investor alive over the long run. Only the mantra of “I don’t know, and I don’t care “ will get you there.

—Jason Zweig, series writer for Money magazine

If you want to see the greatest threat to your financial future, go home and take a look in the mirror.

—Jonathan Clements,financial columnist for the Wall Street Journal

we have completed our journey through the world of fixed income investing. Now that you are an informed investor you should be able to avoid being exploited by those who might take advantage of the lack of knowledge the general public has about fixed-income investing. You should also be able to avoid many of the mistakes individual investors make. Informed investors generally make far better investment decisions.

Hopefully, you now recognize that while the world of fixed-income investing is filled with complexity, the winning strategy is actually quite simple. To summarize, the winning strategy is to:

• Write and sign an IPS that defines your objective, risk tolerance, investment strategy, and eligible securities (i.e., maximum maturity and minimum credit rating).
• Purchase assets from the highest investment grades, generally avoiding instruments with a rating below AA.
• Avoid securities with complex features, as they are products generally meant to be sold (by brokers), not bought (by investors).
• Avoid trying to outperform the market either by trying to guess the direction of interest rates or by trying to identify securities that have been somehow mispriced by the market. There is simply no credible evidence that investors, either individuals or institutions, are likely to succeed in this effort. As Peter Bernstein points out: “The essence of investment theory is that being smart is not a sufficient condition for being rich.” ¹ The winning strategy is to be a buy-and-hold investor.
• Purchase assets with maturities that are short to intermediate in term, avoiding long-term bonds. If the main objective of the fixed-income allocation is to reduce overall portfolio risk, then maturities should be restricted to the short end of the curve (maximum of two to three years). If the goal is to generate greater cash flow or to manage reinvestment risk, then maturities can be stretched to the intermediate part of the curve (five to ten years, depending on the location of the “sweet spot”).
• Avoid the purchase of hybrid securities.
• If using mutual funds (or ETFs) to gain access to the fixed-income market, invest in only very low cost, passively managed vehicles. The same advice applies to selecting separate account managers. Avoid mutual funds that have loads.
• If building your own portfolio of individual bonds, restrict purchases to the primary (new issue) market. This is especially true of municipal and corporate bonds. If, however, you have access to the secondary market through a fee-only advisor or separate account manager who can buy at or near wholesale prices, the secondary market may provide more attractive alternatives.
• Since the prudent strategy is to be a buy-and-hold-to-maturity investor, it is not necessary to “pay up” for liquidity (all else being equal, the more liquid the asset, the lower the yield). Thus investors who plan on holding to maturity should at least consider buying less-liquid securities (e.g., issues from smaller municipalities that do not frequently come to market) for some portion of the portfolio—as long as the credit rating is AAA or AA. Less-liquid securities should not, however, constitute the bulk of your portfolio. The reasons are that there may be unanticipated calls on your capital and there may be opportunities to harvest tax losses. Selling less-liquid securities is likely to result in having to accept large markdowns.
• Review your IPS on an annual basis as well as whenever the assumptions you made about your ability, willingness, and need to take risk have changed.

Hopefully, you have enjoyed the journey through the world of fixed-income investing. It is now time for you to write, and sign, your IPS. As you go through that process we urge you to carefully consider these words of wisdom: “The inconvenience of going from rich to poor is greater than most people can tolerate. Staying rich requires an entirely different approach from getting rich. It might be said that one gets rich by working hard and taking big risks, and that one stays rich by limiting risk and not spending too much.” ²

In closing, we offer these words of caution from legendary investor Pogo: “We have met the enemy and he is us.” Do not take more risk than you have the ability, willingness, or need to take.