Ever see those ads where you can invest and get returns from the stock market, but you’re guaranteed to never lose money and wonder how they could offer such a product? If you wanted to, you could do the same things with your portfolio by using the right mix of stocks and bonds, and holding your investments for a long enough time period. You’ll actually make more that way than you will with one of the “guaranteed” investment products because you won’t be paying out a lot of money in fees.
Let me first say, despite the claims, there is absolutely no way that you can never lose money when investing. You can just make the chances of losing money very low by making the right investment choices. The companies may claim that you can never lose money, but they would simply go bankrupt or look for a government bailout if everything went bad at once. They also have a little more protection than you do when investing on your own since they have a larger pool of money to work with. As long as everyone doesn’t want their money back at once (and they’ll usually protect against this by charging huge fees if you redeem early), they can usually wait for the stock market to recover. This is actually what you should do as well, but you’ll see a loss for a while until it does.
Also, understand that the less chance you have making money, the lower your returns will be. In investing taking prudent risk is how you make greater returns. (Note that term, “prudent” in there. If you take stupid risks you won’t make bigger returns, except maybe for your broker.) Part of protecting your money is to invest in some things that make a lesser return, but are more stable and have a more predictable return.
To understand how things work, you need to understand how stocks and bonds work.
Bonds: A bond is a loan to a company. In exchange for making the loan, they will pay you a specified amount twice a year. At the end of the loan period, the company will pay you the money you loaned them back. At this point, the bond is said to have “matured.” The company can also pay you back early, which can be an issue since this normally happens during a time when interest rates are low, leaving you with few options to get a good rate of return with your money.
So with bonds, you get a specified rate of return (for example, $500 per year or a 5% initial return on a $1000 bond) and at a certain date the company should pay you your money back. Of course, things can happen at the company and they may declare bankruptcy. If that happens, you’ll be first in line to get paid but you’ll be lucky to get a couple of hundred dollars back for your $1000 investment. If you’ve been collecting interest payments long enough before this happens, you’ll have made money. If not, you’ll take a loss. You need to therefore invest in bonds in such a way that you almost guarantee you will not take a loss. Do this by:
- Invest only in the bonds of companies that are financially strong and unlikely to go bankrupt. These are bonds that are AAA or AA rated by the rating agencies. You can buy a few lesser-grade bonds provided the interest rate they are paying are suitably high, but understand a percentage of these will go bankrupt before they mature.
- Invest in several different bonds in different companies rather than investing in just one or two. Think of how unlikely it is that ten or twenty high-quality companies will go bankrupt within the next ten or twenty years. Having one go bankrupt is more likely. Really, investing through bond mutual funds that buy a set of dozens of bonds for you is usually the way to go since you then don’t need to find all of the bonds yourself.
- Try to buy bonds that are below their maturity price. The price of a bond will fluctuate during its life depending on the health of the company and interest rates. Try to buy bonds that cost less than $1,000 per bond (most bonds are worth $1000 at maturity). This way, you’ll get a little extra return when they mature since you’ll get paid $1000 per bond then. If you buy bonds above their maturity price, you’ll lose a little in each bond.
- Buy bonds you can hold to maturity. Your plan is to hold these bonds to maturity so that you won’t care about what happens to the price along the way. If you have ten years, don’t buy bonds that don’t expire for twenty.
Stocks: With common stocks, you’re buying an ownership stake in the company. This means that if the company does well, the value of your ownership stake will increase. There is no guarantee, however. If your company doesn’t do well, you’ll lose money, possibly your whole position.
Stocks provide the opportunity to make a greater rate of return than you can receive with bonds. The value of a company will also keep up with the rate of inflation. If you invest only in bonds, you’ll see your spending power decrease over time. Remember that at the end of the life of a bond you only get the $1000 you loaned the company back – you don’t get $1100 to account for inflation. Conversely, Over long periods of time the price of stocks will increase just because of inflation. Even if the company you buy never makes a higher profit, the price of the shares of stock will increase just because of inflation. Also, the company will be able to charge more when dollars are worth less, so their profit will increase in absolute dollar terms even if they don’t in real dollar terms.
So the underlying philosophy is that you buy enough in bonds such that the interest you receive from the bonds will be enough to offset any losses you may see in the stock portion of your portfolio, plus give you a little but of money each year. That way, you “eliminate” the chance of losing money, yet still have the opportunity to make returns from the stock market. Note that the word, “eliminate” is in quotes because there is still a chance of losing money if things go really badly or you do something silly like see your position after a drop in the markets before it has a chance to recover.
In the next post we’ll go into the details of how to use a combination of stocks and bonds to build a “risk-free” portfolio.
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Disclaimer: This blog is not meant to give financial planning or tax advice. It gives general information on investment strategy, picking stocks, and generally managing money to build wealth. It is not a solicitation to buy or sell stocks or any security. Financial planning advice should be sought from a certified financial planner, which the author is not. Tax advice should be sought from a CPA. All investments involve risk and the reader as urged to consider risks carefully and seek the advice of experts if needed before investing.