The headline in the business section of the NY Times on Sunday declared that “Consumers in the US Face the End of an Era of Cheap Credit.”  The article says that just as we are starting to see some bright spots in the economy, we are about to face a new financial burden…”a sustained period of rising interest rates.”  It even goes as far as saying that the rise is “inevitable” because of our country’s ballooning debt and the possibility of inflation as the economy recovers. 

Higher rates may shock consumers whose spending habits have been shaped by a 30-year decline in the cost of borrowing.  In 1981 the yield on the 10-year Treasury note was almost 16%.  Steadily decreasing rates over the next 30 years fueled a surge in consumer borrowing and spending.  In the turmoil of the recent financial crisis, the yield spent most of the last two years in the 2-3% range.  Last week, it crossed back above the 4% level for a brief period of time before settling just below that level.  So, while rates may move higher, they are coming off historic lows.

If rates do move higher, it means that it will cost more to finance that new car or put that new flat-screen TV on the credit card.  That certainly won’t help the economy.  But, the main impact of higher rates will probably be felt first in the housing market, which is just starting to show some signs of recovery.  The rates on a 30-year fixed mortgage have risen recently, hitting their highest levels since last summer.  And the Fed has put an end to its emergency program to buy mortgage debt, which is putting even more upward pressure on rates.

How should you position your portfolio to prepare for the coming change?  Don’t expect much help from the “best and the brightest” on Wall Street.  The two best economic forecasting teams of the last two years couldn’t disagree more about where the yields on the Treasury note will go.  Morgan Stanley says that they believe the 10-year will rise to 5.5% this year.  Goldman Sachs expects them to fall back to 3.35%.  If the Morgan Stanley prediction comes true, mortgage rates would be somewhere north of 7%.  If Goldman Sachs is correct, it would mean mortgages around 5%.  That’s a huge gap and it illustrates how much the smartest minds in finance and economics can differ.

And that brings us to the main point of this article.  This is just the latest in a long list of reasons why I believe that a passive approach to managing your portfolio is the best way to go.  If the best and the brightest disagree by this much on something as basic as the yield on the 10-year Treasury, what are the rest of us supposed to do?

A passive approach to portfolio management means that you don’t try to play the guessing games about the markets and the economy.  You build your portfolio based upon your own risk tolerance and return needs.  You should be allocated across several asset classes (as many as 16 different asset categories) using an academic and non-emotional approach to investing.  You can gain exposure to these asset classes using extremely low-cost institutional mutual funds.  Then, you only buy and sell when moves in the market require you to rebalance to keep the mix of assets in line.  In effect, you are building a portfolio of indexes which will result in a low cost, globally diversified, tax-efficient portfolio providing the highest return for a given level of risk.