The Proper Role of Bonds in Your Portfolio

Over the years, as I have spoken to quite a few people about bonds, the various conversations have often taken a different direction, depending on the “environment” at the time.  Take, for example, 1999, when common stocks were on a tear; then I had to explain the reasons why anyone would want to invest anything at all in the bond market.  And in recent times, in this “environment” I’ve actually had to talk investors out of investing too much of their money in bonds. 

These are both examples of what Behavioral Economists call “recency.”   Meaning that we tend to place more emphasis (and trust, appropriately or not) on more recent data even as we ignore older data. 

A more general problem, I’ve found, is that investors don’t understand the role that bonds should play in an investment portfolio.  When you buy a bond you are essentially lending money to some entity, whether it’s a corporation, a municipality, a state, or a country.  In exchange for what is essentially your loan, you are promised a regular payment, usually on a semi-annual basis, plus the full amount of the money you lent returned to you at a given date.  Depending on the circumstances, you may or may not realize the promised returns. 

Bonds are considered “fixed income;” investing in them generally means that you will not gain as a result of growth in the economy.  Bonds are considered safe and therefore have a lower expected return than stocks.  But bonds have two inherent risks, namely interest rate risk and, more importantly, credit risk/default risk.  Interest rate risk means that when interest rates rise, bond prices will fall, given the inverse relationship between them. 

Default risk describes what happens when the entity has gotten into financial trouble and does not return your original investment.  Take for example, Greece; certainly you have heard how the threat of Greece defaulting on their bonds is playing havoc with markets there and across the globe. 

Portfolio strategists view bonds as a way to provide stability to a portfolio.  Accordingly, this approach argues for only buying high quality bonds, i.e. those with the highest credit ratings.  The reason is that you won’t want an economy which is going through a “soft patch” to adversely affect both your stock portfolio and your bond portfolio at the same time.  The whole idea is that bonds should provide a safer haven than stocks, albeit with a lower expected return.

Conclusion

It is my belief that, as part of a sensible portfolio, fixed income investments must be limited to high quality issues.  I also believe that it’s a mistake for investors to overemphasize bonds in a portfolio, simply because they are afraid of a bad economy or bearish stock market.

Over the long term, stocks have always outperforned bonds.  And over time, it is the erosion of purchasing power that is the biggest risk for most people.  Most bonds do not protect you from the ravages of inflation.

In the long-term, you need both equity investments for growth and bond investments for stability.  How you make that allocation decision is the most important determinant of how your portfolio will behave in the future.

To be continued.

Driven Crazy by Mad Money’s Jim Cramer

I’ll admit that Jim Cramer is a very colorful character.  He has an opinion on the relative merits of thousands of companies’ stocks, and he seems to personally know the CEOs of each and every one of them.  And he talks way faster than most people can listen.

While I do use CNBC’s web site, I hardly ever watch their TV channel. I always recommend that investors shy away from Mad Money, and in fact all TV shows of that ilk.  You know the kind that “shares” “opportunities” for you or makes predictions on interest rates, stock prices, commodities, etc. etc. etc. 

But my advice is to avoid Jim Cramer, in particular, because he convinces people that the right way to invest is to pick individual stocks, to time the market and to trade.  For most people, this is a formula for losing money.  By trying to “beat” the market, they are more likely to underperform. This isn’t just my opinion; it is supported by actual studies of how well individual investors do.

I have chosen to write about Jim Cramer now, because the last few days have been so dramatic.  I think events indicate that he pretends to, but really doesn’t know, what the future brings. 

If case you weren’t paying attention to the day-to-day swings in the stock market (and good for you if you weren’t), here’s what happened.

On Tuesday, May 31^st, the stock markets had a tremendous rally, i.e. stock prices went up worldwide.  That very night on his TV show, Cramer was beside himself with glee, ranting that this trend was very likely to continue.  As he put it, “We haven’t seen this kind of global move for ages!”

You can watch the May 31^st show:

Cramer: It Will Be Hard to Stop This Rally

Well, in the immortal words of Gomer Pyle (I know I’m dating myself), “surprise, surprise, surprise.”  Since that prediction, just a week ago, the stock market fell over the next four consecutive trading days, on Wednesday, Thursday, Friday and Monday.

So what did Cramer have to say about the four days worth of declines on Monday night’s show?  Sometimes “it’s right to be grim about what’s happened.”

You can view Monday’s show:

Cramer: Market Could Continue to Decline

After the stock market had a large rise, Cramer was terribly optimistic.  After the stock market declined, Cramer has a decidedly downbeat view.  This change happened in one week.  Should you take his views seriously?  I would not, but you must decide for yourself.  Do you want to be buffeted by changes in the day to day stock market?  Or would you be better served by having a sensible long-term plan that takes into account your needs, your goals, and your willingness and ability to take risk?

Conclusion

What will happen next week or next month?  I haven’t a clue.  And that’s the point.  No one can know the future; surely, you’ve heard me say that once or twice.  In my opinion, you don’t have to be a good forecaster to be a good investor.  You need to have a plan, and you need to stick to it. 

Where to find a good planner?  I would start with NAPFA, if you want someone to manage your investments and the Garrett Planning Network, if you are a confirmed do-it-yourself investor.  You will still have to do your own due diligence.  (Disclosure: I am a member of both groups.)

 Friends don’t let friends watch Jim Cramer.