Most people are familiar with the concept of false positives in medical situations. You take a test to see if you have disease, and the result comes back positive – it says you do have the disease. But further tests show you really don’t have the disease. The first test was wrong. It gave a “false positive” signal.
The same phenomenon can occur in any setting. A test wrongly suggests something is true when it really isn’t. This may happen in the Critical Path system that Asset Dedications uses to guide the “roll-don’t roll” decision. This is the decision whether or not to replenish the Income Portfolio by selling equities out of the Growth portfolio as each year passes to replace the most recently matured bonds.
The test to make the roll-don’t roll decision, assuming no other change in a client’s circumstances, is to compare the value of the total portfolio (Income and Growth Portfolios combined) against value of the Critical Path, which indicates what the total should be if everything is going according to plan. If the total is on or above the Critical Path, the Income Portfolio will be replenished by extending it forward another year.
But if the total is below the Critical Path, it would be considered a positive result for the test – in the same sense that a positive result for the medical test indicates the patient may the disease. The portfolio may not be on track to meet its goals. It triggers us to investigate the reasons for the test result to see if it is a false positive or a true positive.
What could cause a false positive? One possible cause is a rise in interest rates. Fixed income securities will fall in value if interest rates rise. Rising rates would likely result in a decline in value for bonds held in an Income Portfolio. This could be enough, theoretically, to decrease the total portfolio value below the Critical path. But it would be a false positive because bonds owned under our strategy are held to maturity. Their face value and coupon payments will remain the same regardless of what happens before they mature. The decline in value only affects people who have to sell them prematurely. The decline below the Critical Path due to falling bond values would be a false positive and can be ignored. The Income Portfolio can be safely replenished when the time comes.
A true positive could occur if the Growth Portfolio has fallen in value due to a market downturn. In this case, it cannot be ignored and the recommendation would be don’t roll. That is, do not sell Growth Portfolio holdings to replenish the Income Portfolio. Skip a year and revisit the decision at the next review to see if equity markets have recovered sufficiently to replenish the Income Portfolio. If not, skip another year and repeat. Since the 1920’s, the average length of a Bear market is 18 months. A true positive could also occur if a client has been overspending.
Since 1981, interest rates have generally been falling and bond values rising. But many analysts believe that 2016 will be the last of that long term trend. The Federal Reserve already raised interest rates it controls by .25% in December 2016 and again in March, 2017. If rates continue to rise, we may begin to see false positives in the Critical Path signals. We will make appropriate recommendations based on each client’s situation, but advisors should be ready to explain why a decline in their portfolio may be a false positive, and why their Income Portfolio may be rolled forward even if it drops below the Critical Path.