Today we’ll go into the strategy more fully and see how to put things into practice. First, let’s talk about the behavior of stocks and bonds.
Stocks: As stated previously, when you buy a stock, you are taking an ownership position in a company. After you buy it, it’s value is determined by what someone else is willing to pay you for it in the future. While you can look at the long-term return for stocks and draw some conclusions about how they will probably perform in the future, there is no guarantee of any rate of return over a given period. Furthermore, the shorter your time period, the more unpredictable your returns will be. Almost all periods of five years have positive returns, while 1-year returns are about 70% positive and 30% negative.
Despite the uncertainty involved (or really, because of it), stocks are an important part of a portfolio. Stocks provide a long-term return that is better than bonds and other fixed-income assets, and holding stocks will allow you to protect your money from inflation. While single stocks can (and do) become worthless from time to time, it would be very unlikely that you could lose everything if you held several different stocks. If you have money you need in a short period of time (five years or less), it should be in cash assets. If you have money that you don’t need for ten years or more, it should be in stocks to protect against inflation and increase returns.
Bonds: Because bonds provide a fixed income, their return is more predictable than that of stocks. This is not to say that the total return of a bond can be predicted exactly, and in fact the price of a bond can change dramatically if interest rates change or if a company gets into financial difficulty. Losses can therefore still occur if the price declines and the investor sells out of the position. Provided bonds are held until they mature, the fluctuations in price of bonds is not important since you’ll get the full coupon price of the bond when it matures. In fact, you can gain a little extra return by buying bonds that are at a price less than their maturity price and then holding to maturity.
Holding single bonds can result in a loss of your entire investment if the company goes bankrupt and is unable to repay the loan. Because of this, several bonds should be bought at once to reduce the damage caused by the loss of any single bond. Again, buying bonds through mutual funds is a good way to accomplish this. Also, bonds should be held for long periods of time, as should bond funds, so that the interest paid by the bonds and the effect of bonds maturing has the ability to reduce or eliminate short-term losses caused by price fluctuations.
Setting up a (nearly) limited risk portfolio: Now that we’ve discussed the behaviours of bonds and stocks, let’s see how to use them to make gains when the stock market goes up but limit or eliminate losses when the market declines. The trick is to use bonds to provide income and stability, while using stocks to benefit from market gains. The more bonds you buy, the less declines in the market will decrease your portfolio value, but the less gains you’ll make when the markets go up.
You should therefore use a percentage of bonds tied to the amount of risk you’re willing to take and the amount of time you have to invest. For example, let’s say that bond funds were paying an interest rate of 5% and you had $100,000 to invest. You want to take almost no risk of a decline in your portfolio value, but you want to participate if the stock market increases in value. Let’s also assume that you don’t need the money for at least five years. (If you have a shorter time period and you really need the money, you should just be in CDs because even bond portfolios can decline given less than five years).
If you put 60% of your portfolio in bonds through a bond mutual fund, you would get a return of $3000 per year from your bonds in interest. If you then invested the remaining 40% ($40,000) in stocks through a stock mutual fund, the interest from the bonds would make up for almost an 8% decline in the value of your stock portfolio. If the stock portfolio increased 10%, you would gain $4,000 from the stock gains and still have the $3,000 from the bond interest, providing a $7,000 total return, or a 7% overall return.
Now if stocks fell more than 8%, or if interest rates went up and your bond portfolio went down in price, you would see a loss temporarily. You would not see this from the commercial products because the company covers these losses. (Note, they also generally require you to hold for a specified period of time since they know it is very unlikely that you will see a loss in either the bond or the stock portfolio if you holld for at least five years.) When there are big gains in the portfolio, however, they keep a good portion of that gain. You would therefore do better on your own since your gains will more, but you may need to see an account value decline a little in a given year, especially really bad years.
Note that you’ll often do much better than an investor who is fully in the stock market during down years if you hold bonds as well. For example, in 2008, many pure stock investors saw 30% declines in the value of their portfolios. Bond investors actually saw the price of their bonds go up as stock investors sold and bought bonds to try to gain safety (note, this is exactly the wrong thing to do, but we’ll talk about that another time). If you had the portfolio described in the example above, you would have seen maybe a 5% gain on your bond portfolio just due to the price going up (+$3,000), a 30% loss in the value of your stock portfolio(-$12,000), and then your normal 5% interest return on from your bonds (+$3000). You would therefore have seen a decline of only $6,000 in your portfolio, or about 6%, when others were seeing a 30% decline. Most years are not that bad, so even a 6% loss would be rare.
If you had then held the portfolio for another year, allowing stocks to recover, you would have ended up gaining about 20% on your stock portfolio (+$5600), plus another $3,000 in interest from your bonds in the next year. After year two, you would actually be up $2400 from where you started at the beginning of 2008.
The issue with increasing bond percentage further is that you are giving up return. And if you go to an all bond portfolio, in fact, you end up increasing risk since now you’ll not have a counterbalance to a decline in bond prices due to rising interest rates.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.