Bonds 8 – Why “making more money” is the worst investment strategy you can have

Susan
By Susan July 18, 2012 08:42

Bonds 8 – Why “making more money” is the worst investment strategy you can have

 

 

If you’ve been reading the series of posts on bonds since the beginning, you should now have a much better picture of the bond market. You understand the characteristics of a bond, you know where to find information about a bond and what to look for in news about the economy.

 

So – now comes the big question. What bond should you pick? What is a good bond to buy at the moment?

 

Wrong question.

 

 

The fallacy of “the” good bond to buy

 

Well, how about buying a 2020 German bond? You know that, although it’s trading at a premium, it has a number of advantages: it is highly likely that your capital will be protected, even though it is unlikely to keep up with inflation; and many people are using this bond as a hedge against the punt depreciating in the event of a Euro collapse. That’s not too bad, considering other bonds on the market…

 

But, I hear you say, it’s trading at a premium, which means you would incur a capital loss (even though you might offset some of it with the income from the bond); and its yield might even be negative – it would underperform that elusive inflation!

 

Oh – so you mean you wanted to do more than just preserve your capital at all costs?! Why didn’t you say so?

 

The thing is, every time I hear the question “So, what’s a good stock / bond to buy at the moment? Any tips?”, I have to cringe. If I got one euro every time I heard it, I would be a rich lady by now. But it’s a very dangerous question.

 

It’s like asking “So, how long is a piece of string? What’s your opinion?”

 

People who ask this question have no idea that there are several criteria to judge a bond by. And they don’t know what they want that bond to do, let alone what they themselves want to do. They have no idea what objective they want to achieve or what comes with the territory of achieving that objective.

 

Bonds (and stocks for that matter) are certainly NOT a one-size-fits-all.

 

For example, I recently bought a high-yield, junk status, corporate bond fund. With an 8% yield, it does more than just keep up with inflation and is diversified to mitigate default risk. Rising prices (and profits), which are delivered by inflation, only serve to decrease the potential for, and amount of, default. Indeed, it’s easier to pay back your debt is a currency that is worth less, while you have been able to raise your prices precisely because the currency is worth less.

 

However, I know what investment strategy fits my stage in life, I know what my investment expectations, my risk profile and my views on inflation are – and I know exactly what the fund actually does.

 

Now this is the other end of the scale, compared to that 2020 German bond: I have bought a fund (several bonds packaged together), as opposed to an individual bond. I have bought junk status, rather than investment grade, and high yield, as opposed to underperforming inflation.

 

Does that sound like what you’d like to buy? Oh, you might say, junk status doesn’t sound too good – it’s money down the drain if they default, and you can’t afford to lose all that money.

 

So you see, “What’s a good bond to buy?” is an invitation to submit the hapless asker to a barrage fire of more questions!

 

There is no one “right bond” to buy. And there is no one “right investor persona” – if you were thinking contrarian investors or investors who invest in “risky” bonds are “wrong”, or investors who play it safe are too conservative to actually make any money, you should think again.

 

You have to compare a bond to your circumstances and your expectations to find the bond most suitable to you, your risk profile and your objectives. But of course to do that, you would need to know what you need and what your objectives are…

 

Also, bonds will not be a panacea. They are certainly underutilized in many portfolios, but they can’t solve every problem! So if you thought the volatility of the stock market meant you were better off investing in bonds, rather than stocks, please (please!) reconsider.

 

Bonds can be a great answer to part of your investing strategy, but remember that they have certain disadvantages, compared to stocks. Their coupon won’t increase, when a dividend generated by a stock might appreciate; inflation eats into their fixed return; there is the danger of default; and of course, they mature, which means you have to look for some other reinvestment opportunity.

 

 

The danger of just “wanting more money”

 

When I ask audiences what they want from financial markets, they laugh and say “Well sure as much money as I can make!”

 

Then I say “Are you willing to risk 90% of your investment to get there?”

 

They suddenly get very sober.

 

“Making as much money as you can” is NOT an investment strategy, but a recipe for disaster, because it does NOT give you clear guidelines to take decisions by. This kind of vague goal opens the door to panic and hesitation. This means that you are a slave to your emotions, which is the worst thing to be when you are an investor, be it in the bond or stock market.

 

So many investors have no clear guidelines – they’re throwing darts in the dark, and it would be a miracle of pure luck if they hit the bull’s eye.

 

Imagine that I’m in Dublin and I want to take the bus to the airport. I wait for bus 16 and get on. But suppose it turns out the number on that bus is wrong and the bus is not going to the airport: then I will get off the bus. The reason I got on the bus is no longer there so I get off, and that’s just it.

 

Or I want, say, Italian food. I walk into a restaurant, but it turns out this restaurant serves Mexican food. The reason I walked into the restaurant, to find Italian food, is no longer there, so I walk out.

 

It is exactly the same with stocks and bonds. You don’t buy or hold them “just because”. You have to have a strategy and certain objectives – and you have to stick to that strategy, not let it gather dust somewhere in a drawer!

 

If you “just” want more money, are you going to buy a German bond at a premium, or are you going to buy a high-yield bond, or securitized, subordinated debt? The German bond is low-risk and low-reward, whereas the other two are much riskier, with higher potential rewards.

 

“I want to make more money” doesn’t help you make up your mind between any of the above! With the German bond you’re pretty sure to make a little more money, whereas with the high-risk bond you might make a lot more money – or lose big time. They will both make more money, but in very different conditions. So, which one do you choose?

 

 

To invest in the bond market, you should have timely and measurable goals

 

Setting effective goals that get you where you want to be is an art in itself – so much so that I have devoted a whole chapter to it in an upcoming book! This is true for financial markets, as well as life in general.

 

Since bonds represent fixed income, you know how much money you will receive and when. In this case – and this only holds for the bond market, not the stock market –, a smart investing objective will include two things: exactly how much “profit” you want to make (not just the revenue, but how much you are prepared to “pay” to reach that level of revenue), and when you want the money (a time range is better than a precise date).

 

Your investment objective has to be measurable and timely.

 

Let us take the following scenario:

 

You are 40, your children are 10 and 13 respectively. It means that in 4 years’ time the oldest will be starting college, and for the youngest that will be in 7 years’ time. Suppose you invest in bonds to put your children through college. How much will you need?

 

You need to take into account tuition fees, accommodation if they have to move to a university town, living expenses (food, various bills) for three to four years. Don’t forget to add xx% to account for inflation, and then add €xxx for a margin of error.

 

You now know that, in 4 years’ time, you will need €xxx approx., and in 7 years’ time you will need €xxx approx. You could receive these amounts in one lump sum when your children begin college, or you could decide that you want to earn the amount corresponding to one year of college, every year, for four years, starting respectively in 4 and 7 years.

 

Now you are in a much better position to decide what to do with your money, considering how much you have now, and how you can invest that money to reach your target amount in the required timeframe. You can sketch different investing scenarios and see whether they allow you to reach your objective of €xxx in the required timeframe.

 

You could never do that if your only objective was to “make as much money as you can”.

 

Of course this is a simplified scenario, since you would have to also ask yourself what portion of your savings or portfolio do you want to keep in bonds, and what will happen if the scenario changes (say, if one of your children gets a scholarship). But you get the idea!

 

Another scenario would be that you are now 45, and you want to invest in bonds to provide supplementary income when you retire. Now you won’t be needing a lump sum, but you will want regular income over several decades (hopefully!). How much supplementary income do you want or need? When would you like to start to receive this income? For how long? Again, considering how much money you can afford to invest now, you can establish a much firmer investing strategy.

 

You might decide that you want €1000 in supplementary income from your investment in bonds, starting in 20 years when you will be 65, and lasting 30 years (better be on the safe side!).

 

Now in this situation, you would perhaps also want to invest in stocks, and progressively reinvest your gains in bonds as your retirement approaches. You would also consider what type of pension options are available, the levels of tax relief, etc.

 

Every time you are faced with an investing decision, you can ask yourself “Will this provide the €xxx I need, in the timeframe that I need it by?” This is a much better position to be in, than just “I want more money”.

 

It will allow you to see much clearer in the tradeoffs you will invariably have to make.

 

Are you on the list?

Sign up for my monthly newsletter and get more content like this, learn about business opportunities, and never miss my Savvy podcast.

 
Previous post: Bonds 7 – How does the state of the economy influence the bond market?

Next post: Bonds 9 – Your bond buying checklist

Facebooktwittergoogle_pluslinkedin
Susan
By Susan July 18, 2012 08:42