The stock market is falling and interest rates are going up. What do I do? If you have a balanced portfolio and no immediate need for the money, in a word, you should do nothing. Clients and regular readers of this newsletter have heard me address the near certainty of rising interest rates and the expectation of continued volatility in both the bond and stock markets. This is not the time to panic and it is especially not the time to sell everything and just hold cash. Market timing is not a game you are going to win long term. However, as I have discussed before, you need to be realistic about your expectations and understand how you can lower your risk profile a bit. The most relevant place to rethink your risk profile is in your bond portfolio. I won’t repeat areas covered in earlier newsletters but suffice it to say that if you haven’t already sold your mortgage funds and converted your long term bond funds to short term bond funds then do it now. The rise in rates may slow but with massive Federal deficits and increasing signs of life in the economy, rates will eventually go even higher. It is important to maintain your bond allocation, just trim the risk profile and do it right away.

But what about those who rely on bond income? This is a bit trickier but still not too hard. If you are confident that you can hold a bond to maturity then keep it. Absent a credit default, you know it will pay you Par at maturity. If you think you may need to sell some of your bonds in a few years then sell them now and replace them with bonds that will mature as you anticipate needing the cash. When in doubt make the maturities shorter. Even though you may give up some yield, as rates move higher you will have the opportunity to reinvest the principal you don’t need at higher rates later.

But interest rates might go up while I own the bonds? You hope interest rates go up while you own the bonds because you get to invest for more yield and income later. In the meantime if the market value of your bonds goes down you really don’t care because you know you will still get par at maturity.

But why not just keep all my bond money in cash until rates go up? Simple, the yield you give up while you wait for rates to rise is usually not recovered unless rates rise very rapidly. Given the fact that the Fed has indicated a desire to keep rates more or less stable for the next year or two, it may take a while before we see a dramatic move toward higher interest rates. Also, if you are relying on income from your bonds it is very unlikely you’ll derive anywhere near enough income from a money market fund to cover your needs.

But aren’t there "deals" out there where I can earn 8 or 9% as long as I don’t need my money back right away? In investing in general and in bonds in particular higher returns mean higher risks. I’ve been shown a number of fixed income like investment opportunities lately that have the potential to offer high yields. The bottom line is that while some are attractive, they all involve taking on more risk. If you can’t properly evaluate that risk and determine if you are being fairly paid for it then don’t play the game. For most people it does not make sense to get involved.

You do have options to help handle the changing risk levels in the markets, take advantage of them. Ignoring your portfolio or panicking to try to avoid losses will never make you happy in the long run.

As always, please feel free to call if you have any questions.

Randy Gridley

August, 2003