(PUB) Investing 2015

DIVERSIFICATION Should You Fly to Safety?

most sensitive to changes in interest rates. With interest rates falling since the early 1980s, Treasurys have had the wind at their back for a long time, but at some point rising rates will become a headwind for Treasurys. Money market funds, with their con- stant $1.00 NAV, are another popular flight-to-safety destination. Their advan- tage over Treasury bonds is that they are not impacted by changes in interest rates. But with money market funds yielding 0.01%, you are almost certainly going to lose to inflation over time. So is there a better alternative? One shock absorber for a stock portfolio that has the potential to make you some money—but that still isn’t very sensi- tive to changes in interest rates—is Short-Term Investment-Grade . This actively managed fund holds a hand- ful of Treasurys but is more focused on corporate bonds, and hence has a higher yield than its Treasury-oriented siblings at Vanguard. The combination of a short maturity profile and relative yield advantage has served the fund well when interest rates rose. In 2013, while its short-term peers struggled to generate any return at all and Total Bond Market Index declined 2.3%, Short-Term Investment-Grade was able to notch a return of 1.0%—tops among all of Vanguard’s actively managed investment-grade bond funds. The fund isn’t without risk and has the potential for price declines. In 2008, anything that wasn’t Treasury-issued was shunned by the market, and this fund suffered for it, declining 7.6% at its low point. However, its resilience can be seen in its short recovery time of just six months. Investors who can tolerate some price moves should do much bet- ter here than in a money market fund over time. Investors who are a bit more sensi- tive to changes in price, but are still looking for something to do with their rainy day money should also consider Vanguard’s new Ultra-Short-Term

yet investors have been much better off staying in the markets. Flying to safety is just another way of saying that investors are trying to time the markets: Something has happened, and they are trying to get out of the market before it gets worse, with the idea of getting back in after the danger is gone. Only it rarely works that way. As the list above shows, predicting what will spark the next bear market is not an easy task. And don’t forget that to be successful in this endeavor, you need to not only avoid the danger but get back into the market after. Still, the flight-to-safety instinct is a strong one, and there will be another bear market, so let’s discuss funds investors commonly turn to for safe- ty—and show why you’ll be better off moving away from the all-or-nothing mindset of fight or flight. Shock-Absorbing Funds For those seeking protection from falling stock prices, U.S. Treasurys remain the flight-to-safety asset of choice, and long-maturity Treasurys provide the most bang for your buck. Consider that Extended Duration Treasury ETF gained 55.0% in 2008 as 500 Index lost 37.0%. Or take the third quarter of 2011, when 500 Index lost 13.9%, and Extended Duration Treasury ETF gained a whop- ping 52.7%. That’s certainly a lot of return to offset declining stock prices, but those returns can slice the other way. Extended Duration Treasury ETF declined 35.6% in 2009 and dropped 17.0% in just the three months end- ing July 2013. Not exactly what I would call a “safe” holding. If you are looking for Treasury bonds to insulate your portfolio, you’d be better off in Intermediate-Term Treasury , which has regularly provided positive returns when stocks were falling, but without the wild ride of long-maturity bonds. Treasury bonds, however, have their own risks. While an effective counter to declining stock prices, they are the

FIGHT OR FLIGHT? These two basic responses to a perceived threat served our ancestors well, but in today’s modern world most people do not face life-or- death situations in their day-to-day that engages their fight-or-flight instincts. Except, of course, when it comes to the stock market, where (at least accord- ing to many commentators) investors are constantly fleeing to safety, or sell- ing first and asking questions later. The fight response might be more appropriate, though. Consider that the U.S. stock market has been in a bull market for more than six years despite myriad “scares” that raised the hair on Wall Street’s neck. Here is an incomplete list of perceived threats that were said to have forced some investors to flee: n Affordable Care Act — passage would kill the health sector n Arab Spring — Middle East chaos n China slowing — global demand would suffer n Comparisons with 1929 — the charts say “Depression” n Cyberattacks — corporations aren’t safe n Cyprus — bank defaults would lead to global disaster n Ebola — a global pandemic n Flash Crash — the markets are unsafe n Grexit, Parts 1 and 2 — the demise of the EU and the euro n ISIS — a world in chaos n Libya — more Middle East chaos n Quantitative Easing — leading to hyperinflation n Sequestration — the U.S. government in chaos n Tapering — without stimulus, the economy would crater n Ukraine, Crimea and Russia — chaos and war-mongering n U.S. debt rating downgrade — the U.S. in trouble n U.S. government shutdown — the U.S. in trouble

Clearly, the list of reasons to avoid the stock market is ever-expanding, and

12 • Fund Family Shareholder Association

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