This is the tenth article in a series that will discuss and explain basic investment concepts in hopefully an understandable and meaningful way. Whether you work with an investment advisor or choose to do your own investing, there are some things you need to know to be successful. Here is my take on what those they are.
In my last column, I bravely suggested that bondholders will find it very difficult to earn any real money (what you get to keep after you pay taxes and inflation on your earnings) for quite a while to come. I also stated that the only reason you should own bonds in your portfolio is to lessen the volatility of the stocks that you must own in your portfolio to have a chance at growing your wealth (make more than taxes and inflation take away from you).
So why bother to own any bonds at all in my portfolio? Because when the world “falls apart” and the stock markets of the world are crashing, everyone buys those safe U.S. treasury bonds, whether they need them or not. The United States government has enjoyed an AAA rating on their bonds for a very long time by numerous credit rating agencies. On August 5, 2011 one of those credit rating agencies (Standard and Poor’s) had the audacity to lower their rating of United States credit worthiness to AA+. This was huge news! This was potentially catastrophic news! Never mind the details on this. Never mind that one could actually make a case that the U.S. is technically bankrupt now because of our huge and growing $20 trillion debt. Forget all that!
As luck would have it, on August 8, 2011 the goings on in Europe caused stock markets to dive across the world. And what did investors do? They bought United States AA+ Treasury bonds like they were going out of style. This buying frenzy drove the prices of those bonds up sharply. And if you had some of those bonds in your portfolio, they (to some extent) lessened the pain of the stocks that fell in your portfolio.
Stock markets of the world go down in value every once in a while. Sometimes those temporary downs are truly frightening. Folks who don’t understand that market ups and downs are regular and quite normal occurrences (that would be most folks) panic, sell their stocks before they go to zero, and buy those very safe U.S. treasury bonds. So, you own some investment grade bonds in your portfolio for those times when the world temporarily comes to an end (on average about every three or four years, but not since 2007). You owned these bonds before the world came to an end as a hedge. Be patient and wait for your stocks to recover. If you know anything about re-balancing, you might even be tempted to sell some of those expensive bonds and buy some of those inexpensive stocks. But that is a discussion for another time.
Michael J. McNamara, Ph.D., CFP®
CERTIFIED FINANCIAL PLANNER™
Disclaimer: Any financial advice in this article is intended to be generic in nature. Readers should consult with their own financial advisors before implementing any advice or suggestions above.