Examining bonds and other lending investments

When you invest your money in a bank certificate of deposit (CD), a Treasury bill, or a bond issued by a company — such as the energy giant Exxon Mobil, for example — you’re a lender. In each case, you lend your money to an organization — a bank, the federal government, or Exxon Mobil. The organization pays you an agreed-upon rate of interest for lending your money and promises to return your original investment (the principal) on a specific date.

Getting paid all the interest in addition to getting back your original investment (as promised) is your hoped-for outcome when you make a lending investment. Given that the investment landscape is littered with carcasses of failed investments, however, this result isn’t guaranteed. The following sections outline what happens when you invest in bonds and discuss some lending drawbacks.

Exploring stocks, real estate, and small-business investments

The three best ways to build long-term wealth are to invest in ownership investments: stocks, real estate, and small business. I’ve found this to be true from my own personal experiences and from observing many clients and other investors over the decades. The following sections outline these three ways in greater depth.

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 five 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 vast 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 might 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 free 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 and then again in the late 2000s), 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. Throwing in the towel 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.