What to Invest In-2014

By in Bond, Investing, Stocks

How to Invest in 2014?

“Everything is worth what its purchaser will pay for it.” Publilius Syrus (1st century BC)

2014 is very different than previous years. What will investor’s be willing to pay for stocks and bonds in 2014? The stock market is up over 20%, but not terribly overvalued (by historical standards). Certainly, the market is not at the lofty valuations of the late 1990’s.

Interest rates are at a generational low. I’m getting a bit long in the tooth, and I’ve never seen interest rates this low.

Unemployment is high, but dropping bit by bit.

So, what is an investor to do? The pundits don’t agree on the best course of action today. And, after doing a complete portfolio evaluation I’m answering this question for my own portfolio; “What to Invest in in 2014”?

Investing Issues in 2014

The most popular investments consist of stocks, bonds, and cash. Some investors like to diversify with commodities and real estate investments as well but today we’ll concentrate on the big three.

Here’s the problem, historically, cash paid the lowest returns with the lowest price volatility. You could expect an average 2 to 3% return on your savings account during the last 70 or 80 years. Stocks paid the highest return with great swings in value. Over the last 80 years, stocks averaged about 9% per year. And bonds were in the middle with a historical return in the range of 5% per year.

Historical Returns of Cash, Bonds, and Stocks

Historical Returns of Cash, Bonds, and Stocks

 

But the returns of stocks and bonds are anything but steady. It’s not unusual for stocks to lose 20 or 30% in a bad year and bonds had negative returns in 2013. To further confuse the scenario, in most of the first decade of the new millennium, bonds outperformed stocks.

In fact, as interest rates rise, investors holding existing bonds and bond funds will suffer loses in their bond portfolio. The reason for this inverse relationship is simple, if an existing bond is paying 1.5% and market rates rise to 2%, no investor will pay full price for a bond paying 1.5% when she can get a new bond paying 2%. Thus, the old bond holders will have to sell their bonds at a discount in order to remain competitive in the rising interest rate environment.

With bond and cash yields in the low single digits, and the economy improving year over year, investor’s piled into stocks, driving prices up.

Investing Questions for 2014

Will the stock bull market continue?

With inflation at rock bottom, interest rates in the basement, stocks will more than likely continue to advance. Investors are left with few higher yield alternatives for their investment cash. It’s unlikely stock market returns will be in the high 20% range next year, but their returns will more than likely be positive.

Will interest rates rise?

The ten year Treasury Note interest rate is 3%. That means you buy a ten year Treasury note and you can expect a 3% annual rate of return. Looking back on historical averages, that’s on par with the historical return on a plain savings account. Not very enticing.

With interest rates so low, it’s likely they will increase. But when and by how much remains to be seen. It’s tough to make a prediction on future interest rates.

If interest rates trend upward, investors will have a chance at higher money market and bond yields.

Investing Answers for 2014

Cash Alternatives

In my recent US News and World Report article, “The Best New Savings Vehicle You’ve Never Heard of“,  I wrote about Floating Rate Notes. These newest US Treasury offerings have a floating interest rate which is tied to the 13 week treasury bill rate.

What does this mean for investors?

Investors in Floating Rate Notes will enjoy increasing returns when the short term interest rates rise. Although rates are low now, buy these safe government notes and when interest rates rise, so will your returns. (Conversely, when interest rates decline, so will your returns).

Bond Alternatives

This is a tough category. As stated above, when interest rates rise, the returns on bonds fall. If you’re invested in a bond fund, there is no end date, so you can’t hold the bond until maturity and hope to get back the bond’s face value. I know this may be controversial, but all but the shortest term bond funds are likely to have a negative return in 2014, if interest rates rise. Funds holding longer term bonds with greater durations will fall mare than shorter term bond funds.

If you have a large portfolio, consider investing in individual short term corporate bonds. For a 2 year A rated Corporate bond, expect to earn 1.62% annualized yield. Go out  a bit further out and invest in a 5 year, higher rated AAA corporate bond for a 2.13% yield.

 

Bond Yields-December 29, 2013

Bond Yields-December 29, 2013

 

This bond yield and return chart plots expected returns for a variety of time periods for various types of bonds. Notice that higher quality bonds pay lower rates of return than lower rated bonds. Also, shorter term bonds offer lower returns than longer term bonds (holding other variables constant).

Although interest rates are low right now, another government security, I bonds offer a yield tied to the inflation rate. When inflation increases, so will your investment return. My family invests the maximum allowed each year and although the rates are currently low, your principal purchasing power is protected if inflation kicks in.

Stock Alternatives

This is a difficult category. In general, it’s tough to properly “time the market”. Research has proven time and again that jumping in and out of the market reduces your overall returns.

Review your asset allocation and make sure it fits in with your current stage in life and risk tolerance. Continue dollar cost averaging into diversified index funds. Stay the course, and be aware of the properties of stocks. They are the most volatile asset class meaning their returns jump around from year to year.

Most professionals suggest stocks will have a positive return this year. The reason? The economy continues to improve and there aren’t many investment alternatives to stocks, with such low interest rates.

Remember, don’t have any money in the stock market you expect to need in the next 5 years.

Don’t forget that investing is a marathon when you consider “What to Invest In in 2014“. Over the short term, anything can happen. Over the long haul, money invested in the financial markets compounds.

Readers, what are your investing plans for 2014?

image credit; Bond yields_Fidelity.com