Kyle is the bestselling author of The Personal CFO, Founder of Atlas Wealth Advisors, and Co-Founder of L&H CPAs.
When it comes to long-term investment strategy, one of the most important concepts to understand is calculating risk versus reward. You want to look for investments that come with the highest potential for reward and the lowest potential for catastrophic risk.
Sometimes, though, investors do the opposite. Their investments offer small, incremental rewards in the face of big potential risks. One of my favorite thinkers, Nassim Taleb, created a metaphor to make this concept easier to understand. He coined the term (pun intended) “picking up pennies in front of a steamroller.” He’s talking about the potential to make a little, with the potential to lose a lot.
I want to apply this concept to a specific asset class in 2021: U.S. government bonds. Let’s talk about how pennies and steamrollers relate to this type of investment.
U.S. Government Bonds In 2021
U.S. government bonds have traditionally been considered a “safe” asset. But we can evaluate their risk-reward potential using the pennies-and-steamrollers metaphor. Let’s start with pennies.
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“Pennies” refer to your potential to gain on your investments. As of this writing, the 20-year treasury rate is 2.11%. That means you can buy a 20-year government bond that pays you 2.11% interest for the next 20 years.
But you can’t collect pennies from the road without looking out for steamrollers. The “steamroller,” in this case, is rising interest rates. As a rule for bond investing, you can think about the relationships between bond prices and interest rates like a seesaw. When interest rates increase, bond prices fall.
This is exactly what has happened to U.S. government bonds recently. In the past 12 months, the small increase in interest rates has led to a large decrease in the value of bonds. Those who have been picking up pennies, or investing in these bonds, have seen their portfolios drop in the past year. This took place even though investors generally consider these bonds a “safe” asset. But the pennies in front of a large, looming steamroller don’t offer a great risk-reward trade-off.
Let’s look long-term. How does this trend over the past 12 months impact the way investors move forward? Here are two things to analyze:
• History of bond rates: When you look at bond rates historically, they have actually been on a slow decline for 40 years. That tells you this may not be a 12-month fluke that took place in 2020, an unpredictable year in many ways, but that it’s been an ongoing trend to be aware of.
• Interest rates continuing to increase: Moving forward, it’s possible interest rates can continue to rise. Rising interest rates are always a future possibility, especially with concerns of inflation.
What does this mean? While no one can predict the future (it’s 2021 — who knows what’s next?), you can compare your potential for risk to your potential for reward. In this case, there’s a large steamroller making its way toward the pile of pennies. In other words, it’s possible the value of bonds will continue to drop.
Next Steps For Long-Term Investors
Remember: When it comes to long-term strategy, investors want to look for investment opportunities with the highest possible potential for reward and the lowest potential for catastrophic risk. The pennies-and-steamrollers analogy is a good one to apply to any investment — not just U.S. government bonds. A good next step would be to dive into your portfolio and evaluate your investment strategy with a few questions:
• What do I own?
• Why do I own it?
• What is each investment’s potential for pennies?
• Are there any lurking steamrollers that could hurt my portfolio?
Taleb’s analogy helps investors make clear, confident decisions about investments. It doesn’t propose investors should avoid risk at all costs. Instead, it provides a practical approach to weighing risk against reward to make investment decisions.
A great financial advisor can do the same. Talk to your financial advisor about your risk tolerance and your long-term investment plan. Together, you may find opportunities to pick up hundred dollar bills in front of a tricycle instead of pennies in front of a steamroller.
The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.