A Moral Dilemma

A Moral Dilemma


Growing up, I spent grades one through twelve attending Catholic schools, meaning that along with reading, writing, and ‘rithmetic I received a daily dose of religious education. For the teachers reading this, I was the kid who asked too many questions, rarely accepting anything at face value. You know the one—that smug, annoying student who keeps raising his hand to ask, “Why?,” (or more appropriately in sixth-grade speak, “How come?”) instead of allowing the lesson to proceed according to plan. So when the topic of morals was covered in religious studies class, I always had a field day posing various moral dilemmas to my poor, unsuspecting teacher.

Thou shall not steal. What if I stole a loaf of bread to feed my starving children? Thou shall not kill. What if it was done in self-defense or to protect an innocent person? Of course, my questions were impossible to answer because the problem with morals is their lack of flexibility and inability to consider the context of a situation. You don’t ask questions; you just follow them—which was the typical response from my teachers.

Recently, I wrote an investment proposal for an institutional client. To prepare for my proposal, I had to review the organization’s investment policy statement, which called for an allocation of 50% stocks, 40% bonds, and 10% cash. Rather than contemplate how I would approach investing their assets, I found myself asking why the organization had to invest according to the same allocation at all times. Thou shall invest half of thy portfolio in stocks. What if the stock market was ridiculously overvalued? Thou shall invest 40% of thy portfolio in bonds. What if rising interest rates loomed?  Thou shall maintain a 10% cash allocation. What if cash yielded 0%?

As strange as it may seem, this organization’s investment policy is not out of the ordinary. While the ratio is not always 50/40/10, asset allocations like these are commonplace in our industry and not just with institutional accounts. If you own a “balanced” mutual fund, you are likely being bound by a rigid asset allocation. From the prospectus of the Fidelity Balanced Fund: “(The fund invests) approximately 60% of assets in stocks and other equity securities and the remainder in bonds and other debt securities.” If you make a practice of rebalancing your portfolio periodically to keep in line with a “target” allocation, your asset allocation is just as rigid. If you own a “target date retirement” fund, your asset allocation changes as you age but still fails to respond to market conditions.

Asset allocations are the product of crunching historical investment return data to determine the appropriate mix of assets for your specific return needs and risk profile. Need a 7.5% annual return with about half of the stock market’s volatility to meet your retirement goal while allowing you to sleep at night? There’s an app for that. It’s called a portfolio optimizer, and it would tell you that a portfolio of 50% large-cap stocks and 50% intermediate government bonds would meet your risk and return requirements.

But, while the optimizer is capable of spitting out the “right” allocation for your goals, it is typically based on large sets of historical data (since 1926 in my example), which means it fails to take context into consideration. Data since 1926 assumes a 9.6% return on large cap stocks and a 5.4% return on intermediate government bonds, both of which are elevated given current market conditions. We project that large-cap stocks will produce gains of 7% to 8% over the next ten years—a respectable return but significantly less than the 9.6% average annual return over the last 80+ years. Intermediate government bonds are easy to project because they require no projection. The yield on the 10-year U.S. Treasury bond stands at less than 4% currently, a far cry from the 5.4% historical return. So, in what appears to be a low return environment relative to history, does it make sense to rely on asset allocations that are based on returns from headier times?

So far, I have kept my example simple by assuming a two-asset portfolio comprised of stocks and bonds. However, cash is certainly a part of everyone’s asset allocation. Cash may have once been king, but now it is more like the emperor with no clothes now that it yields less than 1%. It is still important to have cash to serve as your emergency fund, but your allocation to cash needs to be put into the context of your personal investment plan. Having too much cash may make you feel secure, but it will negatively affect your investment return. With a long-term return of just 3.7%, cash has always been a drag on returns but never to the extent it is today with sub-1% yields.

Regardless of the sad state of the cash markets currently, target date retirement funds like the Fidelity Freedom 2005 Fund continue to ramp up their cash exposure. The Fidelity fund is designed for investors who retired in 2005. Despite the fact that these investors are just five years into their retirement plan and despite the low yields on cash, this fund has 15% allocated to “short-term funds”—half of which is invested in a Fidelity money market yielding 0.24% with the other half invested in the Fidelity Short-term Bond Fund, which yields 1.7%. And per the fund’s investment objective, the cash allocation will continue to gradually increase until it reaches 40% in 5 to 10 years! Given today’s longer life expectancies, few retirees are in a position to live off of a portfolio in which nearly half of their assets yield less than 1%.

Morals fail as a reliable code of conduct because of their inability to adapt to various situations. Unfortunately for many investors, their investment plans may too fail in the coming years because their asset allocation refuses to adapt to the unique market conditions that exist today and are likely to persist into the near future. If you want to make certain that your asset allocation is in line with your goals, please contact us.

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