Are you falling into conventional wisdom trap?
If you have been following these posts you probably know by now that I’m not a big fan of conventional wisdom. Why? Because in the financial world it seems that the conventional wisdom is created by those who think that certain market conditions will persist forever. Unlike the scientific world, this wisdom is rarely tested. We usually just accept the conventional wisdom without question.
For example, we have always been told that certain investments are safe and others are risky. We usually accept this without much thought. Take stocks and bonds for example. The conventional wisdom has always been that, in general, stocks are risky and bonds are relatively safe.
Let’s rethink this for a minute. While it’s true that once you own a bond it will pay you the stated interest rate until maturity, did you know that the price (or value) of bonds works in an opposite direction from interest rates? What this means is that as interest rates go up, the price of existing bonds will go down. Let’s look at an example; let’s say you own a bond that is paying 3% interest and rates go up to 6%, how many people are going to want your bond? Not many. That means that if you want to sell your bond the price will have to go down. Remember, the good news is that while the value of your bond may decrease, in most cases it will still provide the same income until maturity.
This is not the case with a bond mutual fund or a Target Date fund. Since you don’t control the individual assets in the fund, if interest rates go up the price of the funds will go down. This will probably come as a huge shock to those holding these funds and a big reason I’m not a big fan of Target Date funds. The illusion of managing risk by investing in these funds may cost you dearly and probably at the worst possible time.
With interest rates hovering at zero, eventually rates will have to go up. When will that happen? Who knows? What you should know is how the eventual higher rates will affect your portfolio. What will this mean to those investments in your portfolio that conventional wisdom or lack of understanding tells you are safe? Ignoring the conventional wisdom and gaining an understanding of how higher interest rates can affect your assets and financial plan may just eliminate some sleepless nights.