Risk #1: Falling Behind Inflation
Seeking the safety of cash investments, such as money markets? You may not find exactly what you're looking for. Inflation has averaged 2.13% since 2000, but money markets have only averaged 0.13% during that same time.* Money market returns have beaten inflation twice since 2000, but when inflation wins, you could get negative “real” returns (i.e., the returns after subtracting the rate of inflation).
Seek to Avoid Negative “Real” Returns
Historical Money Market Returns After Inflation
Data from 1/31/2000 to 3/31/2021. Source: FactSet, Bloomberg, American Century Investments. Money markets are represented by the Citi 3-Month Treasury Bill Monthly Return (left side). Inflation is the 12-Month U.S. Inflation Rate (right side). The inflation rate is annual calculated every month. Past performance is no guarantee of future results.
*Money market returns are represented by the FTSE 3-Month U.S. T Bill Index from January 2000 to March 2021. Inflation returns are represented by the Consumer Price Index. Data from January 2000 to March 2021.
What Can You Do?
Consider investments that have the potential to outpace inflation. Bonds, particularly those designed to fight inflation, can also help. They provide more return opportunities than money markets, plus they typically aren’t as volatile as stocks.
Want a deeper dive into inflation preparation? Bond expert Robert Gahagan leads you through the current drivers of inflation and what it means for your portfolio.
Risk #2: The Extremes
You’ve probably seen this warning in the fine print: Past performance is no guarantee of future results.
But in general, certain investments do have characteristics that make them more or less likely to perform a certain way. Stocks have the potential for high growth—but also major losses. Bonds are typically less volatile but can still have wide swings. Money markets rarely have high returns but don’t have a high risk of losses.
Seek a Smoother Ride
Best and Worst Years 1980-2020
This chart is for illustrative purposes only. It does not constitute investment advice and must not be relied on as such. Assumes reinvestment of all income and no transaction costs or taxes. The Balanced Portfolio consists of 10% T-Bills, 35% bonds and 55% U.S. stocks. The Balanced Portfolio is neither a real, nor recommended portfolio. It was rebalanced each January. All investment returns are compound annual returns.
Sources: Data as of 12/31/2020. Morningstar Direct. Federal Reserve Bank of St. Louis. American Century Investments®. U.S. Stocks data: S&P 500® Index, U.S. Bond data: Bloomberg U.S. Aggregate Bond Index, T-Bills data: 3-Month Treasury Bill: Secondary Market Rate represents the average interest rate at which Treasury bills with a 3-month maturity are sold on the secondary market.
Stock and bond returns assume reinvestment of all income. Past performance is not an indicator of future performance.
What Can You Do?
So which should you pick? A mix of all three types of investments might help you balance any extremes that pop up over your investing time frame. If your portfolio is heavy on either stocks or money markets, it could be time to strengthen your bonds.
Risk #3: Your Tax Burden
Your portfolio might be positioned for various market conditions, but is it prepared for taxes? The amount you pay in taxes can cut into the returns you receive from your investments.
Many people incorporate specific strategies to cope with their tax bill, including investing in tax-free bonds.1 Taxable bonds might provide higher returns, but tax-free bonds have the potential to make up for the gap with their tax-friendly status.
Here’s how to calculate the difference:
The tax-equivalent yield can help you compare taxable and tax-free bonds: It’s the return that a taxable bond needs to earn to equal the yield on a comparable tax-free bond.
Tax-Free vs. Taxable Bonds
Comparing Hypothetical Tax-Equivalent Yields
This hypothetical situation contains assumptions that are intended for illustrative purposes only and are not representative of the performance of any security.
Federal tax rates used to calculate tax-equivalent yields: Moderate Tax Bracket – 28%; High Tax Bracket: 40.8%.
Source: American Century Investments, IRS.gov, as of May 2021.
What Can You Do?
Municipal bonds (munis), which are loans to cities, states and other political entities, are a common type of tax-free bond. Muni interest is free from federal taxes (and sometimes state and local taxes) and may help you build a more tax-efficient portfolio.
Even though a bond mutual fund is designed to purchase assets exempt from federal taxes, there is no guarantee that all of the fund’s income will be exempt from federal income tax or the federal alternative minimum tax (AMT). Fund managers may invest assets in debt securities with interest payments that are subject to federal income tax and/or federal AMT. State and local taxes may also apply.
IRS Circular 230 Disclosure: American Century Companies, Inc. and its affiliates do not provide tax advice. Accordingly, any discussion of U.S. tax matters contained herein (including any attachments) is not intended or written to be used, and cannot be used, in connection with the promotion, marketing or recommendation by anyone unaffiliated with American Century Companies, Inc. of any of the matters addressed herein or for the purpose of avoiding U.S. tax-related penalties.
This information is for educational purposes only and is not intended as tax advice. Please consult your tax advisor for more detailed information or for advice regarding your individual situation.
Investment income may be subject to certain state and local taxes and, depending on your tax status, the federal alternative minimum tax (AMT). Capital gains are not exempt from state and federal income tax.
Generally, as interest rates rise, the value of the securities held in the fund will decline. The opposite is true when interest rates decline.
Investment return and principal value of security investments will fluctuate. The value at the time of redemption may be more or less than the original cost. Past performance is no guarantee of future results.
This material has been prepared for educational purposes only. It is not intended to provide, and should not be relied upon for, investment, accounting, legal or tax advice.