Investing in bonds

When you invest in a newly issued bond, you lend your money to an organization. The bond includes a specified maturity date — the time at which the principal is repaid — and a particular interest rate, or what’s known as a coupon. This rate is fixed on most bonds. So, for example, if you buy a ten-year, 5 percent bond issued by Boeing, the U.S. aircraft manufacturer, you’re lending your money to Boeing for ten years at an interest rate of 5 percent per year. (Bond interest is usually paid in two equal, semiannual installments.)

Some types of bonds have higher yields than others, but the risk-reward relationship remains intact. A bond generally pays you a higher rate of interest when it has a

• Lower credit rating: To compensate for the higher risk of default and the higher likelihood of losing your investment
• Longer-term maturity (how many years until bondholders are paid back): To compensate for the risk that you’ll be unhappy with the bond’s set interest rate if the market level of interest rates moves up

A bond’s value generally moves opposite of the directional change in interest rates. For example, if you’re holding a bond issued at 5 percent and rates increase to 6 percent on comparable, newly issued bonds, your bond decreases in value. (The reason: Why would anyone want to buy your bond at the price you paid if it yields just 5 percent when 6 percent can be obtained elsewhere on the same types of bonds?)

Bonds differ from one another in the following major ways:

• The type of institution to which you lend your money: With municipal bonds, you lend your money to a state or local government or agency; with Treasuries, you lend your money to the federal government; with corporate bonds, you lend your money to a corporation.
• The credit quality of the borrower to which you lend your money: Credit quality is a measurement of the likelihood that the borrower will default on the interest and principal you’re owed. Knowing this information is important because higher-credit-rating bonds are generally safer but pay lower rates of interest.
• The length of the bond’s maturity: Short-term bonds mature within 5 years, intermediate bonds mature within 5 to 10 years, and long-term bonds mature within 30 years. Longer-term bonds generally pay higher yields but fluctuate more with changes in interest rates.
• The bond’s callability: Callability means that the bond’s issuer can decide to pay you back earlier than the previously agreed-upon date. This event usually occurs when interest rates fall and the bond issuer wants to issue new, lower-interest-rate bonds to replace the higher-rate bonds outstanding. To compensate you for early repayment, the bond’s issuer typically gives you a small premium over what the bond is currently valued at.

Considering the downsides to lending

Many folks think that lending investments are safe and without risk, which is wrong. Lending money has the following disadvantages:

• You may not get what you’re promised. When a company goes bankrupt, for example, you can lose all or part of your original investment.
• Your money’s purchasing power may be reduced by inflation. Many folks have grown complacent with the low inflation the United States has enjoyed for quite some time. But what if inflation increases to 6 percent per year, or even 10 percent per year, as it last did in the early 1980s? After a decade of that much inflation, the purchasing power of your money drops 44 percent at 6 percent annual inflation and a whopping 61 percent at 10 percent yearly inflation. Also, the value of a bond may drop below what you paid for it if interest rates rise or the quality/risk of the issuing company declines.
• You don’t share in the upside of the organization to which you lend your money. If a company grows in size and profits, your principal and interest rate don’t grow along with it; they stay the same. Of course, such success should ensure that you get your promised interest and principal.

Socking your money away in stocks

Stocks, which represent shares of ownership in a company, are the most common ownership investment vehicle. You’re an owner when you invest your money in an asset, such as a company or real estate, that has the ability to generate earnings or profits. Suppose that you own 100 shares of Apple stock. With billions of shares of stock outstanding, Apple is a mighty big company — your 100 shares represent a tiny piece of it.

What do you get for your small slice of Apple? As a stockholder, you share in the company’s profits in the form of dividends (quarterly cash payments to shareholders from the company) and an increase (you hope) in the stock price if the company grows and becomes more profitable. Of course, you receive these benefits if things are going well. If Apple’s business declines, your stock may be worth less (or even worthless!).

As the economy grows and companies grow with it and earn greater profits, stock prices and dividend payouts on those stocks generally increase. Stock prices and dividends don’t move in lockstep with earnings, but over the years, the relationship is pretty close.

In fact, the price-earnings ratio — which measures the level of stock prices relative to (or divided by) company earnings — of U.S. stocks has averaged approximately 15 the past two centuries (although it tends to be higher during periods of low inflation). A price-earnings ratio of 15 simply means that shares of a company’s stock, on average, are selling at about 15 times the company’s earnings per share.

When companies go public, they issue shares of stock that people can purchase on the major stock exchanges, such as the New York Stock Exchange. Companies that issue stock are called publicly held companies. By contrast, some companies are privately held, which means that they’ve elected to sell their stock only to senior management and a small number of invited, affluent investors. Privately held companies’ stocks don’t trade on a stock exchange, thus limiting who can be a shareholder.

Not only can you invest in company stocks that trade on the U.S. stock exchanges, but you can also invest in stocks overseas. Many investing opportunities exist overseas. If you look at the total value of all stocks outstanding worldwide, the value of U.S. stocks is in the minority.

A good reason for investing in international stocks is that when you confine your investing to U.S. equities (another word for stocks), you miss a world of opportunities, like taking advantage of business growth in other countries, as well as diversifying your portfolio even further. (For more on diversification, see the later section “Spreading Your Investment Risks.”) International securities markets traditionally haven’t moved in tandem with U.S. markets.

Investing in the stock market involves setbacks and difficult periods, but the overall journey should be worth the effort. Over the past two centuries, the U.S. stock market has produced an annual average rate of return of about 9 percent (which translates into about 6 percent per year after subtracting inflation). However, as anyone who has invested in stocks over the years has experienced firsthand, stocks can drop sharply — worldwide, stocks were sliced approximately in half during the down market that ended in early 2009. During the government-mandated COVID-19 economic shutdowns in early 2020, stocks plunged about 35 percent in just a few weeks. So if you can withstand down markets here and there over the course of many years, the stock market is a proven place to invest for long-term growth.

You can invest in stocks (and bonds, which I discuss earlier in this chapter) by making your own selection of individual stocks or by letting a mutual (or exchange-traded) fund do the selecting for you.

Generating wealth with real estate

Real estate is another financially rewarding and time-honored ownership investment. Real estate can produce profits when you rent it for more than the expense of owning the property, or you sell it at a price higher than what you paid for it. I know numerous successful real-estate investors (myself included) who’ve earned excellent long-term profits.

Over the generations, real-estate owners and investors have enjoyed rates of return comparable to those produced by the stock market. However, like stocks, real estate goes through good and bad performance periods. Most people who make money investing in real estate do so because they invest over many years and do their homework when they buy to ensure that they purchase good property at an attractive price.

The value of real estate depends not only on the particulars of the individual property but also on the health and performance of the local economy. When companies in the community are growing and more jobs are being produced at higher wages, real estate does well. When local employers are laying people off and excess housing is vacant because of overbuilding, rent and property values fall.

Buying your own home is a good place to start investing in real estate. The equity in your home (the difference between the home’s market value and the loan you owe on it) that builds over the years can become a significant part of your net worth. Over your adult life, owning a home should be less expensive than renting a comparable home. See Chapter 7 for the details on buying and financing your home.

Going the small-business investment route

Many folks have also built substantial wealth through small business. You can participate in small business in a variety of ways. You can start your own business, buy and operate an existing business, or simply invest in promising small businesses. See Chapter 9 for more details.

Opting for options

In recent years, I’m finding that some young people are using options, such as call options, to try and make big money quickly. If you don’t understand call options, I’d almost rather not explain them to you because I’d rather you stay away from them! But here’s a simple example to explain how they work.

Suppose you’re intrigued by the emerging field of artificial intelligence and you hear about the company C3 AI and its stock. You look and see that the stock is trading at $140 per share. Instead of buying the stock, though, you could buy some C3 AI call options. Their $170 call options, which expire in about eight months, are going for just $28 per share. Suppose in the next six months the stock were to zoom higher and hit $300 per share. Your call options would be worth at least $130 per share now, so you would have more than quadrupled your money — a far greater percentage move than you would have enjoyed with the stock. However, if the stock were to instead tread water or go down, your options would end up expiring worthless and you would have lost all the money you invested in them.

So, with options, you are making a short-term bet or gamble on the price of a particular stock rather than making an investment for the years ahead. So, you not only have to be right about the specific stock you are choosing, but you also have to be correct about the specific (short-term) timing of your investment.

Put options work the opposite of call options. If you’re expecting a stock’s price to go down in the near future, you might profit through buying a put option for that stock.

Calculating cryptocurrencies

In addition to options, I see interest in cryptocurrencies among some young adults today. Bitcoin, the most well-known and highly traded cryptocurrency, has been making headlines as its price climbs to ever dizzying heights. It recently hit breached $61,600 per coin. But there are literally thousands — more than 8,000 at recent count — of other cryptocurrencies.

So, what exactly is Bitcoin (and other cryptocurrencies)? For starters, it’s not actually a coin — that’s a marketing gimmick to make it sound like a real currency. Bitcoin and other similar cryptocurrencies only exist in the online world. Bitcoin’s creators say that they have limited the number of Bitcoins that can be mined and put into online circulation to about 21 million.

As its promoters have talked up its usefulness and rapid rise, many people who have Bitcoins continue to hold onto them like shares of stock in the next Amazon, Apple, or Tesla, hoping for and expecting further steep price increases. People don’t hoard real currencies with similar pie-in-the-sky hopes for large investment returns.

Online cryptocurrency transactions can be done anonymously, and they can’t be contested, disputed, or reversed. So, if you buy something using cryptocurrencies and have a problem with the item you bought, that’s too bad — you have no recourse, unlike, for example, a purchase made on your credit card. The clandestine nature of cryptocurrencies makes them attractive to folks trying to hide money or engaging in illegal activities (criminals, drug dealers, and the like). And hackers create another real danger — your cryptocurrency could be stolen as has happened to numerous Bitcoin and other crypto holders.

So, what is a given cryptocurrency like Bitcoin worth? Cryptocurrencies have no inherent value. Contrast that with gold. Not only has gold had a long history of being used as a medium of exchange (currency), but gold also has commercial and industrial uses. Furthermore, gold costs real money to mine out of the ground, which provides a floor of support under the price of gold in the range of $1,000 to $1,200 per ounce for most miners, not far below the price of gold at about $1,700 per ounce at the time of this writing.

While the supply of Bitcoin is currently artificially limited, Bitcoin is hardly unique — it’s one of thousands of cryptocurrencies. So, if another cryptocurrency is easier to use online and perceived as attractive (in part because it’s far less expensive), Bitcoin will tumble in value.

Even though Bitcoin has been the most popular cryptocurrency in recent years, few merchants actually accept it. And, to add insult to injury, Bitcoin users get whacked with unfavorable conversion rates, which add greatly to the effective price of items bought with Bitcoin.

I can’t tell you what will happen to Bitcoin’s or any other cryptocurrency’s price next month, next year, or next decade. But I can tell that it has virtually no inherent value as a digital currency, so those paying big bucks for a particular cryptocurrency will likely eventually be extremely disappointed. There are more than 8,800 of these cryptocurrencies, and the field keeps growing as creators hope to get in on the ground floor of the next cryptocurrency that they hope will soar in value.

Noting leveraged and inverse ETFs aren’t investments

Since their introduction in 2006, leveraged and inverse exchange-traded funds (ETFs) have taken tens of billions of dollars in assets. Leveraged ETFs purport to magnify the move of a particular index, for example the Standard & Poor’s (S&P) 500 stock index, by double or even triple in some cases. So, a double-leveraged S&P 500 ETF is supposed to increase by 2 percent for a 1 percent increase in the S&P 500 index.

Inverse ETFs are supposed to move in the opposite direction of a given index. So, for example, an inverse S&P 500 ETF is supposed to increase by 1 percent for a 1 percent decrease in the S&P 500 index.

The steep 2008 decline in stock market indexes around the globe and increasing volatility theoretically created the perfect environment for leveraged and inverse ETFs. With these new vehicles, you could easily make money from major stock market indexes when they were falling. Or, if you were convinced a particular index or industry group was about to zoom higher, you could buy a leveraged ETF that would magnify market moves two- or even threefold.

Suppose back in early 2008, when the Dow Jones Industrial Average had declined about 10 percent from its then-recent peak above 14,000, you were starting to get nervous and wanted to protect your portfolio from a major market decline. So, you bought some of the ProShares UltraShort Dow 30 ETF (trading symbol DXD), which is an inverse ETF designed to move twice as much in the opposite direction as the Dow. So, if the Dow goes down, DXD goes up twice as much and you make money.

This ETF did indeed rise sharply when the Dow fell sharply in mid to late 2008. By late 2008, with the Dow down about 40 percent, the ETF, rather than being up 80 percent, was only up about 50 percent. In early 2010 — two years after you bought the ETF in early 2008 — the Dow was down about 20 percent. So if you held on that long, your original thinking — that the market was going to fall — proved to be correct. If the ETF did what it was supposed to do and moved twice as much in the other direction, it should have increased 40 percent in value over this period, thus giving you a tidy return. But it didn’t — not even close. The ETF actually plummeted nearly 50 percent in value!

My overall investigations of whether the leveraged (and inverse) ETFs actually deliver on their objectives show that they don’t. Over the years, ETF issuers have come out with increasingly risky and costly ETFs. Leveraged and inverse ETFs are especially problematic.

Buried in the fine print of the prospectuses of these ETFs, it usually says that these ETFs are only designed to accomplish their stated objectives for one trading day, so they are only really suitable for day traders! Of course, few investors read the dozens of pages of legal boilerplate in a prospectus.

Leveraged and inverse ETFs are not investments. They are gambling instruments for day traders.

For you as an individual investor, if you happen to guess right before a short-term major market move, you may do well over a short period of time (longer than one day but no more than a few months), but the odds are heavily stacked against you.

You can reduce risk through sensible diversification. If you don’t want 80 percent of your portfolio exposed to stock market risk, invest a percentage you’re comfortable with and don’t waste your time and money with leveraged and inverse ETFs.

Establishing goals and risks

Before you select a specific investment, first determine your investment needs and goals. Ask yourself: Why are you saving money? What are you going to use it for? Establishing objectives is important because the expected use of the money helps you determine which investments to choose.

For example, suppose you’ve been accumulating money for a down payment on a home you want to buy in a few years. You can’t afford much risk with that money. You’re going to need that money sooner rather than later. Putting that money in the stock market, then, is foolish because the stock market can drop a lot in a year or over several consecutive years.

By contrast, when saving toward a longer-term goal that’s decades away, such as retirement, you’re better able to make riskier investments, because your holdings have more time to bounce back from temporary losses or setbacks. You may want to consider investing in growth investments, such as stocks, in a retirement account that you leave alone for many years.

Comparing the risks of stocks and bonds

Given the relatively higher historic returns for ownership investments like stocks, some people think that they should put all their money in stocks and real estate. So what’s the catch?

The risk with ownership investments is the short-term drops in their value. During the last century, stocks declined, on average, by more than 10 percent once every five calendar years. Drops in stock prices of more than 20 percent occurred, on average, once every ten calendar years. Real-estate prices suffer similar periodic setbacks.

Therefore, in order to earn those generous long-term returns from ownership investments like stocks and real estate, you must be willing to tolerate volatility. You absolutely should not put all your money in the stock or real-estate market. You shouldn’t invest your emergency money or money you expect to use within the next several years in such volatile investments.

The shorter the time period that you have for holding your money in an investment, the less likely growth-oriented investments like stocks are to beat out lending-type investments like bonds.

When you invest in stocks and other growth-oriented investments, you must accept the volatility of these investments. That said, you can take several actions, which I discuss in this chapter and in Chapter 12, to greatly reduce your risk when investing in these higher potential–return investments. Invest the money that you have earmarked for the longer term in these vehicles. Minimize the risk of these investments through diversification. Don’t buy just one or two stocks; buy a number of stocks. Keep reading for more information about diversification.

Understanding why diversification is key

Within a given class of investments, such as stocks, investing in different types of that class (such as different types of stocks) that perform well under various economic conditions is important. For this reason, mutual funds and exchange-traded funds, which are diversified portfolios of securities such as stocks or bonds, are a highly useful investment vehicle. When you buy into funds, your money is pooled with the money of many others and invested in a diverse array of stocks or bonds.

Diversification reduces the volatility in the value of your whole portfolio. In other words, your portfolio can achieve the same rate of return that a single investment may typically provide with less fluctuation in value.

Keep in mind that no one, no matter whom he works for or what credentials he has, can guarantee returns on an investment. You can do good research and get lucky, but no one is immune from the risk of losing money. Diversification allows you to reduce the risk of unnecessarily large losses from your investments.

Allocating your assets

Asset allocation refers to how you spread your investing dollars among different investment options (stocks, bonds, money market accounts, and so on). Over the long term, the asset allocation decision is the most important determinant of total return and risk for a diversified portfolio. Before you can intelligently decide how to allocate your assets, you need to ponder a number of issues, including your present financial situation, your goals and priorities, and the pros and cons of various investment options.

Although stocks and real estate offer attractive long-term returns, they can sometimes suffer significant declines. Thus, these investments aren’t suitable for money that you think you may want or need to use within, say, the next five years.

Money market funds and shorter-term bond investments are good places to keep money that you expect to use soon. Everyone should have a reserve of money — about three to six months’ worth of living expenses in a money market fund — that he or she can access in an emergency. Shorter-term bonds or bond mutual funds can serve as a higher-yielding, secondary emergency cushion.

Investing money for retirement is a classic long-term goal that most people have. Your current age and the number of years until you retire are the biggest factors to consider when allocating money for long-term purposes. The younger you are and the more years you have before retirement, the more comfortable you should be with growth-oriented (and more volatile) investments, such as stocks and investment real estate. Bonds can also be useful for diversification purposes. For example, when investing for retirement, placing a portion of your money in bonds helps buffer stock market declines.

A useful guideline for dividing or allocating your money between longer-term-oriented growth investments, such as stocks, and more-conservative lending investments, such as bonds, is to subtract your age from 110 (or 120 if you want to be aggressive; 100 to be more conservative) and invest the resulting percentage in stocks. You then invest the remaining amount in bonds.

For example, if you’re 25, you invest from 75 (100 – 25) to 95 (120 – 25) percent in stocks. You invest the portion left over — 5 to 25 percent — in bonds. Consider allocating a percentage of your stock-fund money to overseas investments: at least 20 percent to as much as 50 percent for more aggressive investors.

Holding onto your investments and shunning the herd

The allocation of your investment dollars should be driven by your goals and desire to take risk. As you get older, gradually scaling back on the riskiness (and, therefore, growth potential) of your portfolio generally makes sense.

Don’t tinker with your portfolio daily, weekly, monthly, or even annually. Every three to five years or so, you may want to rebalance your holdings to get your mix to a desired asset allocation, as I discuss in the preceding section. Don’t trade with the hopes of buying into a hot investment and selling your losers. Jumping onto a “winner” and dumping a “loser” may provide some short-term psychological comfort, but in the long term, such an investment strategy often produces subpar returns.

When a particular investment is all over the news and everyone is talking about its stunning rise, it’s definitely time to take a reality check. The higher the value of an investment rises, the greater the danger that it’s overpriced. Its next move may be downward.

During the late 1990s, for example, many technology and Internet stocks had spectacular rises, thus attracting a lot of attention. However, the fact that the U.S. economy is increasingly becoming technology-based doesn’t mean that any price you pay for a technology stock is fine. Some investors who neglected to do basic research and bought into the attention-grabbing, high-flying technology stocks lost 80 percent or more of their investments in subsequent years — ouch!

Conversely, when things look bleak (as when stocks in general suffered significant losses in the early 2000s, then again in the late 2000s, and in early 2020), giving up hope is easy — who wants to lose money? However, investors who forget about their overall asset allocation plan and panic and sell after a major decline miss out on a potential rebound in the market and a tremendous buying opportunity. We like buying televisions, computers, and cars on sale. Yet when the stock market is having a sale, many investors panic and sell instead of looking for bargains. Have courage and don’t follow the herd.

Don’t let a poor string of events sour you on stock investing. History has repeatedly proven that continuing to buy stocks during down markets increases long-term returns.

Selling your stocks is the worst thing you can do in a slumping market. And don’t waste time trying to find a way to beat the system. Buy and hold a diversified portfolio of stocks. The financial markets reward investors for accepting risk and uncertainty.