This is the ninth 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 things are.
You need to own some bonds in your portfolio, but probably not as many as you think. Actually, I don’t think you should own any bonds in your portfolio until you are at least 45 years old. The reason for owning bonds in your portfolio is to muffle the volatility of the stocks in your portfolio. It is a difficult proposition to build wealth with bonds. My definition of building wealth is to have your money make more than inflation and taxes take away from you. That should be your definition as well.
An example is in order. Let’s go back to January 1981 and buy an absolutely guaranteed thirty year treasury bond paying 12.14% interest for $10,000. The 12.14% is not a misprint. Whoa, these were the good old days when interest rates were high. In 1981, if your income was between $35,000 and $45,000 you were in the 43% federal tax bracket. Massachusetts income taxes in 1981 were 5.38%. Inflation in 1981 was 13.58%. Here is the math on your $10,000. With 13.58% inflation, that $10,000 will buy $8,642 of stuff at the end of 1981. The math on the interest on $10,000 was $1,214 minus taxes of 43% and 5.38%. So your $10,000 in capital has shrunk to $8,642 in real money. Your $1,214 in interest is really $627 after taxes. If you did not spend the $627 then your original $10,000 plus interest is now worth $9,269. This is your real money. You think you earned $10,000 plus $1,214 and have $11,214. You actually lost more than 7% after taxes and inflation. You lost more if you didn’t re-invest your interest. Money is only as good as what you can buy with it. You only get to spend what is left after taxes and inflation. It is really hard to make “real” money in bonds.
As I write this article, the 30 year U. S. Treasury bond is paying about 3%. We have 2% inflation for the next few years and you are in the 25% federal tax bracket, how much real money do you figure you will make in this investment?
It gets worse. If interest rates move higher, you will lose even more money on your bonds. You buy that 3% Treasury bond mentioned above now and decide to hold it as an investment. Let’s say that sometime later, new Treasury bonds being issued are paying 6%. How much do you think your 3% bond is worth in a world of 6% bonds? Who is going to give your $10,000 for your 3% bond when they can get a new one at 6%? As an extreme example, your 3% bond is worth about $5,000. It is worth $5,000 whether you sit with it or sell it. You lose. In the real world, bonds do not exactly work quite like this, but I think you get the point. If you own bonds and interest rates go higher, it is likely that they will decline in value.
So, back to the beginning. You need some bonds in your portfolio strictly to reduce the volatility of the stocks you hold in your portfolio. There are some times when you will be glad that you own some bonds. Just don’t expect them to make you wealthy or preserve what wealth you have.
All articles in this series will be posted on my website McNamaraFinancial.com. If you have any question or comments I can be reached at mike@McNamaraFinancial.com. I promise I will respond.
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.