Investing - the word alone connotes stocks and bonds. Diversification is the sister term associated with investing. Subtract your age from 100 to figure out how much of an allocation in bonds you should own. Why do we need to have bonds? And what makes bonds a necessary portfolio companion? While trying to understand portfolio allocation slightly better, I came up with the following points.
First, Some Basics
Bonds are relatively simple to understand; they’re loans with a specific duration. They pay interest at stated dates. There’s an issue date and a maturity date. The issue date is the beginning of the loan, and the maturity date is when the principal is paid back to the investor. Therefore, unlike stocks that you own forever, bonds are a temporary loan to the issuer.
Types of bond instruments:
Money markets are mutual funds that invest in short-term debt instruments.
CDs are bonds issued by banks or credit unions.
Bonds are debt instruments issued by a governmental institution or a corporation.
Bonds are necessary for wealth protection
Investment allocation is the panacea to protecting invested assets. According to Rick Van Ness, author of Why Bother With Bonds, managing investment allocation is equally as significant as your ability to save money.
Investing in stocks is a way to gain from the growth of the economy. However, stocks and crypto are risky every year, every day of the year. If you are investing, boring as they may be, you need bonds.
Bonds dilute risk. They soften the blow when the stock market tanks. For example, a loss of 50% in a portfolio of only stocks would only suffer a 25% loss if 40% of the portfolio was invested in bonds. While no one wants to lose money, the latter situation is better than the former situation. This occurs because high-quality bonds have almost no correlation to the stock market. Correlation refers to the relationship of the behavior between two investments and the impact on value. In other words, if the stock market goes up, a highly correlated investment will also go up. Bonds turn left when stocks turn right. Therefore, an investment with no correlation to stocks will not move in the same direction as the stock volatility, offering stability when the stock market is charging up or dropping like a stone.
If you’ve ever heard of the phrase Modern Portfolio Theory, this is what they’re talking about. Modern Portfolio Theory dictates that an asset can be added to the mix of a portfolio, and if its value sensitivity moves in an opposite direction of the existing assets, volatility is reduced, and the portfolio is optimized for maximum return.
Bonds Lack Suspense
Bonds are not entirely risk-free but have much less risk than stocks and crypto.
The most significant bond risk is on high-yield bonds from companies with a low credit rating. Otherwise known as ‘junk’ bonds, they are highly correlated with stocks, meaning that they lose value when stocks tank.
All bonds are subject to interest rate risk, including government-backed bonds
Interest rates are the only unpredictable factor related to bond investing. Bond prices move inversely to the interest rate. If the interest rate goes up, a bond’s value decreases. Why?
Suppose an investor entered into a 5-year bond with a stated 5% interest rate, and shortly after, the interest rate moves up to 6%. In that case, this investor is missing out on the additional 1% because of being locked into the 5% investment for 5 years. That makes the 5% bond’s market value less desirable. The cost of missing out is reflected in the bond price, which fluctuates in the 5 years that the bond is held. Treasury bond prices can fluctuate contingent upon prevailing interest rates and investor confidence.
Summary
I am constantly asked about when I think the next stock market crash or crypto crash will be. It seems like the 2008 stock market crash, or the 2018-2020 crypto bear markets, was just yesterday, and it’s hard for people to erase it from memory, especially those wanting to retire early.
Stocks and crypto are expensive and feel overblown. Are they? We don’t know for sure. What we do know is that stock and cryptos market swings are based on investor emotion. Owning bonds is the antidote to stock investments that take us to artificial highs to disappoint by slamming back down to earth. I would instead take control where I can. If bonds are the way to portfolio protection, I’m signing up.
Thank you for reading and hope you have a good rest of the day!
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