Diversification and Bonds
This week let’s review two more finance terms from the YouGov poll: diversification and bonds. Now we’re starting to get into terms that about 60% of people tend to be comfortable with.
Honestly, I’m a little surprised that people weren’t more comfortable with “diversification”. I understand some confusion about “bonds” because, well, bonds can be confusing. But diversification is a concept in wide use, right? We even have catchy sayings about not putting all our eggs in one basket.
My guess is that folks understand the concept but not how it applies to investing. Assuming that to be true, here is my real-world-financial-planner explanation of diversification. Oh, and for bonds too.
Diversification – Assume you had $1,000 to invest back in 2002. You wanted the money to grow and weren’t afraid of losing it. This was right around the time of the first iPod but still five years before the global phenomenon of iPhone. Maybe you loved your iPod and thought you’d invest in Apple. We know now that this would have been a great investment.
If you were able to ride out the low points (there were many) and not sell shares along the way, you would have made over $100,000 from your initial investment. Maybe you’d consider yourself an amazingly astute investor. Maybe you’re honest and would consider yourself simply lucky. Either way, you’re still in the money.
Or you could have invested in Webvan, the biggest flop of the dot-com era. You could have invested after the company’s Initial Public Offering in late-1999 at about $25 per share. It was exciting times. The grocery delivery service was riding high in the press and you might have been counting your millions… for about a month. Shares fell precipitously into the new decade and would eventually trade for pennies per share the following summer.
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These two wildly different investment outcomes should emphasize why it’s important to diversify. Instead of plunking down all our money on one stock, we should hedge our bets by buying many different investments. By doing so we’re accepting a tradeoff that’s all about managing risk. We’ll never fully participate in Apple’s meteoric return, but we won’t fail completely along with Webvan either.
We take this concept to the nth degree by buying index funds that own hundreds or even thousands of stocks. (We do this for bonds as well.) This essentially diversifies away the risk of any single stock torpedoing our portfolio. Diversification… ignore it at your peril.
Bonds – Don’t let their seemingly boring aura sway you, bonds really are interesting. And using them effectively can help you accomplish your planning goals.
Fundamentally, bonds are loan contracts between a borrower (Apple Inc, the state of California, the U.S. Treasury) and investors (you). You can make a new loan to the borrower in what’s called a “new issue” bond, or you can buy a bond that already exists but someone else has sold it. The bond market, by the way, is valued at about $40 trillion in the U.S. compared with about $30 trillion for the stock market.
Bonds have a specific lifespan and normally pay interest at set intervals. Every six months is common. These regular interest payments are the main reason why most investors own bonds: for income. The bond’s value moves around while you own it, but you don’t really expect your bonds to grow much. If you own the bond when it matures the original loan amount, or what’s known as the bond’s “par value”, gets paid back to you.
As with personal credit, bond borrowers have ratings as well. The U.S. Treasury is the benchmark for good credit (don’t laugh) and has a AAA rating, the highest available. Apple is a smidgeon below this but is considered in the running for the coveted rating. A company like Tesla, on the other hand, has its credit rating down in the B’s, part of an area referred to as “non-investment-grade”, or what used to be known simply as “junk”.
Just like with a mortgage or a car loan, the better your credit rating the lower you’d expect your interest rate to be. Apple could expect to pay about 2% to borrow while Tesla’s cost is approaching 8%. This is all about investors trying to ensure they get paid for what’s called “default risk”, or the risk that the borrower can’t make interest payments, or even goes belly up and can’t pay back principal at maturity.
There are any number of stories about companies going bust and not paying back bondholders. Some bond investors lost their shirt during the financial crisis, for example, because they had sunk too much money into too few high-risk bonds. Other investors played it safe, were appropriately diversified, and rode out the storm.
The short-hand: use bonds as a tool to provide current income and to act as ballast in your investment portfolio.
Here’s a link to a summary of the YouGov poll:
Have questions? Ask me. I can help.
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