Investing is Not a Competition Between Stocks and Bonds

Jane Young, CFP, EA

Many investors think of investing as a competition between investing in the stock market, interest earning investments and real estate.  Too many people take a strong stance for or against one of these three broad categories rather than embracing the advantages that each one can bring to their portfolio.  A well balanced portfolio should include some of all three with each serving a very different purpose.

All three categories will have their day in the sun depending on the investment climate.  Due to low rates, interest earning investments such as CDs, bonds and savings accounts aren’t getting much love right now.   Despite the current low rates of return, interest earning investments provide a relatively safe place to keep your short term money.  This is money needed to cover living expenses or emergencies over the next several years.  Interest earning investments provide a buffer against more volatile investments in the stock and real estate markets.   Keeping a portion of your portfolio in safer, fixed income investments can give you greater peace of mind and help you stick to your long term plan when the stock market gets rocky.  However, avoid putting too much in interest earning investments; this can make it difficult to keep up with inflation and earn the growth needed to support your retirement goals.

On the other hand, when the stock market is doing well everyone wants to get a piece of the action. Avoid overloading your portfolio with stock when the market is skyrocketing.   Investments in the stock market can provide you with long term growth and a hedge against inflation.  Historically, the stock market has trended upward and over long periods of time has outperformed other investment categories.  However, in the short term the stock market can be very unpredictable and volatile and should only be used for long term needs – money that isn’t needed for five to ten years.  Keep your short term money in interest earning investments.

Real estate serves a dual purpose for most investors, it gives us a place to live and it provides us with an asset that usually appreciates over time.   In addition to your home, as your portfolio grows, you may want to consider additional real estate investments in mutual funds or rental property.  Like the stock market, real estate should be treated as a long term investment.  The real estate market can experience extreme downturns and commonly lacks the liquidity needed to cover short term needs.

These three categories of investments have their advantages and disadvantages.  Focus on the role the asset plays in your financial plan and avoid becoming overly comfortable and confident with a single category – it’s all about balance.  The appropriate amount in each category will vary over time and is dependent on your age, your financial goals, your cash flow needs and your risk tolerance.

Selecting the Right Asset Allocation – Part 2

Jane Young, CFP, EA

Jane Young, CFP, EA

Your asset allocation is the basic structure of your investment portfolio defining the target percentage you want to hold in different categories of assets.   Start creating your asset allocation by deciding how much you want to invest in the two major categories, stock mutual funds and interest earning assets.  Next break your allocation down into more specific categories including cash, CDs, bonds, large cap stock, mid-cap stock, small cap stock, international stock, emerging markets stock and real estate.  Setting an appropriate, well diversified asset allocation helps you balance risk and return within your portfolio.  Your asset allocation may change over time as your financial circumstances change.  However, avoid changing your allocation too frequently based on short term fluctuations in the market.

The appropriate allocation depends on several factors including your age and investment time horizon, your financial goals, other risk factors in your life, your experience with investing and your emotional risk tolerance.  Regardless of your investment goals, you need to maintain an emergency fund of readily available funds equal to at least four months of expenses.

Your financial goals are a major determinant in setting your allocation.  Identify your major financial goals and when money is needed to support these goals.  Design an asset allocation to meet these goals.  Money needed in the short term should be held in safer, interest earning investments. The stock market should only be used for long term needs – generally at least five to seven years out.

You may be able to assume more risk in your portfolio if the timetable for your goals is flexible.  The timeframe for money to cover things like college education or your emergency fund may be firm but there may be some flexibility on when you take a major vacation, remodel your home or plan to retire.   Money needed for retirement is generally spent over twenty or thirty years.  You won’t need your entire nest egg on the first day.

Your allocation is also dependent on risks taken in other areas of your life.  For example, if you work in a volatile career with unpredictable earnings, own a small business or own rental property, you may want to reduce the risk in your investment portfolio. On the other hand, if you have a secure job and anticipate a generous pension, you may be comfortable taking more risk.

Regardless of your situation you need to feel emotionally comfortable with your allocation. If you are constantly worried about market fluctuations you may need a more conservative allocation.   Historically the stock market has trended upward, but there will be years with negative returns.  Create an allocation that gives you adequate emotional security to ride out swings in the stock market and helps you avoid selling when the market is down. If you are new to investing, start out slowly and test the water to see how you will react in a volatile market.

Risk and Your Investment Portfolio – Part 1

 

Jane Young, CFP, EA

Jane Young, CFP, EA

Deciding upon an asset allocation is one of the first and most significant decisions to be made when you start investing.  Your asset allocation is the percentage of different types of investments such as cash, bonds, stock or real estate that make up your investment portfolio.  Probably one of the most important allocations is that between investments in the stock market and investments in interest earning vehicles such as bank accounts, CDs and bonds.  An ideal asset allocation provides a balance between risk and return that helps you meet your goals but doesn’t keep you awake at night.

There is a trade-off between risk and return.  Generally, if you want a higher return you need to assume a higher level of risk.  Investment risk comes in many different forms with the most common being stock market risk.  Historically, over long periods of time, the stock market has out-performed most other investments.  However, in the short term it can be extremely volatile, including years with negative returns.  In the extreme case you could lose your entire investment in an individual stock.  To reduce risk in the stock portion of your portfolio, consider buying diversified stock mutual funds. You will still experience swings in the market but fluctuations in any one stock will have less impact.

On the other hand, interest earning investments such as bank accounts, CDs, bonds and bond funds are generally less risky and are not subject to stock market fluctuations.  Unfortunately, in exchange for this lower level of risk you may earn a much lower rate of return.

Additionally, bonds and bond funds are subject to interest rate risk and default risk.  If you purchase a bond or bond fund and interest rates increase, the value of your investment will decrease.  To make matters worse, when interest rates rise bond funds commonly experience a flood of redemptions forcing them to sell bonds within the fund at a loss.  Even if you hold on to your shares you can experience a drop in value. However, if you purchase an individual bond and hold it till maturity you will receive the full value upon redemption.   Use caution when buying low quality bonds or bond funds; you may get a higher return but you are subject to a much greater risk of default.

Many investors don’t consider inflation risk.  This results from taking too little risk with a conservative portfolio containing little or no stock.  Over time inflation has averaged about 3% annually, if you are only earning 2% on your portfolio your real return after inflation will be negative.  This is compounded if inflation rates rise significantly.  Consider increasing your allocation in the stock market to hedge against inflation risk.

In the current environment of low interest rates and high volatility it’s crucial to build a portfolio that balances risk and return to support your financial goals and provide you with peace of mind.

Investment Risk Comes in Many Forms

Jane Young, CFP, EA

Jane Young, CFP, EA

One of the first steps when investing money is evaluating your tolerance for risk.  The amount of return you can earn is heavily dependent on how much risk you are willing to take.   We generally associate investment risk with market risk, or the possibility of losing money due to fluctuations in the stock market.   The stock market is volatile and can be a high risk investment if you have a short time horizon.  However, over long periods of time, the stock market has trended upward.  It’s important to consider your tolerance for stock market risk when building your portfolio.  However, the risk of losing money due to a drop in the stock market is only one of many risks that can adversely impact your financial security.

Although fixed income investments are generally considered safer than the stock market, they are not without risk.  Fixed income investments can include CD’s, bonds, bond funds and cash accounts such as money market or savings accounts.  The most common types of risk associated with fixed income investments are interest rate risk and default risk.

Interest rate risk is the possibility of your bonds dropping in value when interest rates increase.  When interest rates increase, the value of an existing bond decreases to compensate for higher interest rates available on the market.  Generally, if you buy and hold an individual bond till maturity, you will get back the full face value plus any interest that was earned.   However, when you own a bond fund,  you don’t have control over when bonds within the fund are sold.  When interest rates rise, bond managers may be forced to sell bonds at inopportune times due to the large number of withdrawals.

Individual bonds have less interest rate risk than bond funds, but they have a higher degree of default risk.  Default risk is the possibility of losing your principal if the bond issuer becomes insolvent.  Bond funds are able to reduce the default risk by pooling your money with others and investing in a large number of different companies or municipalities.

 Treasury bonds and FDIC insured CD’s provide what is generally considered a risk free rate.  If held to maturity, there is very little chance of losing principal.  Your investment is insured by the Federal government against default risk, and you have control over when you sell.  The primary downfall with this type of investment is the extremely low rate of return.

Investing too much in extremely safe, low earning investments often results in inflation risk.  Money placed in “safe” investments with a low rate of return can’t keep up with inflation, resulting in a negative real return.   You also lose the opportunity to earn a reasonable rate of return needed to grow your retirement account.   It’s all about balance; you need to take some market risk to build and maintain your retirement account and stay ahead of inflation.

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