When the market goes up, risk tolerance is infinite, but when it goes down, risk tolerance is often at zero.
OUR POSITION THAT investments in safe bonds is the key to your financial success is a controversial one—especially among brokers. Many investors believe that all diversification results in a reduction of their investment risk. Our concern is that in the name of diversification, these individual investors place a substantial amount of their nest egg in risky investments that they may not understand and ultimately take on more risk than they can actually sustain. Individual forays into risky investments either exhilarate us with their gains or leave us in a puddle of miseries.
It's easy to be misled if one looks only at the historical return of an investment or asset class instead of focusing on the risks involved to realize that return. A higher return means more risk, and more risk means that losses—yes, losses—are more likely. Overlooked tax consequences may severely reduce the expected return of an investment. Up-front, yearly, and back-end fees substantially reduce returns, whether you win or lose.
We believe that individual investors should match their investment assets with their financial needs (for example, retirement and education expenses), rather than speculate in the markets. If safe bonds are the core of your investment assets, you will be able to align your investments with your financial and life goals. This book will show you why you should do this, and how it can be done.
The old guarantees of job security, adequate Social Security benefits, and a company pension plan have been revised if not rescinded and the long-term values of our homes are in question. Despite these uncertainties, bonds can be the unbeaten path to secure investment growth and a way to limit the risk of investment loss without losing out on substantial income and gains.
Simply stated, the 100 percent bond portfolio is a portfolio of safe bonds that will result in a secure cash flow while minimizing your investment risks. The 100 percent bond portfolio is a tried-and-true method that savvy individual investors have been using for generations.
The 100 percent bond portfolio investment strategy can enhance and enrich your life in a number of ways. We struggled for years with how to best satisfy the financial needs of our clients before we developed the 100 percent bond portfolio.
The portfolio is designed to provide the following advantages:
It delivers better returns than other asset classes if you take into consideration the risks, taxes, fees, transaction costs, and the general bad timing of individual investors.
It can be customized to your goals and needs.
It provides a very low-risk investment. We've never lost a cent and you're not likely to either if you buy plain-vanilla bonds, safe individual bonds denominated in U.S. dollars, and hold them until they come due.
It provides income and growth. Come what may, you will have a safe and predictable return on your money.
Execution costs are low. There is generally no commission payable when you buy a bond. There is, however, a cost to you called a "spread," which is the difference between the price the broker paid for the bond and the higher price at which he sells the bond. Spreads on plain-vanilla bonds are generally small. If you buy bonds at their initial offering, the spread will generally be zero.
You need to make only one right decision because bonds repay their face value on their due date. With all other investments, you have to make two right decisions: when to buy and when to sell.
Constructing the portfolio is a simple process to understand, and you can do it yourself.
Investing in the 100 percent bond portfolio has a number of life-enhancing characteristics. Investing your money in plain-vanilla bonds reduces your exposure to market volatility and decreases your investment risk, which will reduce the anxiety level in your life. life has enough problems and concerns without worrying about the ups and downs of your investments every day.
A plain-vanilla bond portfolio represents an economical and safe alternative for your investment needs and diversifies some of the risk of other investments you may own, such as a business, real estate, and collectibles. Bonds give you core stability and enable you to be more adventurous in other areas of your life. For example, when your bond portfolio is large enough, you may decide to change your life by changing jobs or taking other chances in life. When your assets are safe and liquid, you're better able to deal with the bumps in the road of life.
The concept of the 100 percent bond portfolio is now a new and better way for individual investors to deal with their anticipated and unanticipated transitions and deal with their financial problems. Investors can plan for unanticipated transitions and emergencies, such as an accident, disability, medical issues, or support for children and parents, by owning bonds that are easy and inexpensive to sell or to use as collateral for a loan. Investors can also plan for anticipated expenses, such as college costs, a first or second home, or retirement and a second career, by having bonds come due at the time they will need cash for these expenses.
Streams of income. When drafting a financial plan, financial advisers generally track two streams of income: the client's earned income and the client's total return on financial investments. Generally, a client's earned income is viewed as fixed and stable, and the investment income is considered variable and separate from the earned income. We believe that the concepts should be reversed. Your cash flow from a portfolio of plain-vanilla bonds should be your fixed base and will keep you safe; and your earned income should be the variable because it may vary and may cease altogether for a time or forever if you quit your job, retire early, get laid off, or become disabled.
For example, if you are self-employed, the earned income from your business may vary greatly from year to year. These days even an individual working on straight salary may find himself out of work at any time due to the rapid changes in an employer's business. How do you smooth out your cash flow? If your funds are invested in a portfolio of safe plain-vanilla bonds, you will know how much interest income is coming in for sure each year. Your earned income will be your variable. You will be more financially secure as your interest income increases.
Figure 2.1 is a diagram that outlines how your cash flow would support you in good times and bad. If you needed regular monthly payments, the funds would be there for you. If you did not need the income, you could reinvest the funds and have your portfolio grow. That is how bonds provide growth as well as income.
If you were beginning your investment program, you might buy U.S. savings bonds or certificates of deposit (CDs) because of their safety and low cash minimums. With $1,000, you could purchase corporate bonds or Treasury bonds. If you had $5,000, you could purchase a tax-free municipal bond. You pick the year you want the bond to come due.
The hard facts. There are at least three ways for you to secure your financial future:
Increase your wealth so that you have the option of early retirement.
Decrease your expenses.
Continue to work forever.
Decreasing expenses and increasing your interest income from bonds is a safe and sound way to achieve a less stressful financial life. It also may enable you to accept a job that you love even though it pays less. The 100 percent bond portfolio is your passport to a richer, more flexible, less stressful life.
Although we know that getting aggressive with your investments may create great wealth, it may also result in a financial disaster. If you decide not to invest all your money in bonds, we recommend that you keep at least a portion of your portfolio in plain-vanilla bonds. This will enable you to keep at least some assets safe for emergencies, changing jobs, or starting a business. You'll know that there are some assets that will always be there safe and sound. See Part Five for a wealth of investment-planning ideas.
Constructing the 100 percent bond portfolio is a simple process, and you can do it yourself. You purchase only plain-vanilla bonds. Detailed instructions on how to purchase individual bonds are provided in chapter 13.
We describe in Part Three all the different varieties of bonds you might invest in. However, the 100 percent bond portfolio focuses on what we refer to as plain-vanilla bonds. Plain-vanilla bonds are the most suitable bonds for individual investors because they have the following characteristics in common:
They are individual bonds that come due on a specific date.
Their principal is essentially risk free. For example, a Treasury bond or a U.S. Agency bond will not default. The default rate on municipal bonds is historically less than 1 percent, and those defaults are generally in predictable sectors.
They are easy to buy at a fair price.
They can be sold easily and quickly (this is called liquidity).
The cost of buying them is little or nothing.
They are denominated in U.S. dollars, rather than foreign currency.
They are easy to understand and evaluate.
Examples of plain-vanilla bonds include:
Safe cash equivalents, such as short-term Treasury bills and CDs.
U.S. Treasury bonds and Treasury inflation-protected securities (TIPS) (see chapter 6).
U.S. savings bonds (see chapter 7).
U.S. Agency bonds (see chapter 8).
Highly rated municipal bonds and insured municipal bonds (see chapter 10).
Corporate bonds AA-rated or better (see chapter 11).
Foreign bonds AA-rated or better, are denominated in U.S. dollars that are called "Yankee" bonds (see chapter 11).
The 100 percent bond portfolio does not include risky bonds. Our reason for this is the "sleep factor": We don't buy any bonds that will prevent a good night's sleep. Investments in risky bonds create the same kind of anxiety as investments in gyrating stocks. If you buy a portfolio of risky bonds, there is a risk that one or more of them may default. And you may not make enough on the risky bonds to compensate for that loss. For those reasons, the definition of plain-vanilla bonds excludes the following types of bonds and securities:
Low-rated bonds such as high-yield bonds (also called "junk" bonds) and emerging-market bonds, which generally have a significant risk of default (see chapter 11). In the early 1990s, 30 percent of so-called high-yield bonds defaulted.
Any bonds denominated in a foreign currency, such as euros, which have significant currency risk. The foreign currency may decline against the U.S. dollar and result in a loss because the buyers in this case spend their money in U.S. dollars.
Many types of mortgage-backed securities, which carry high risks that are hard to define because of the complexity of their structures (see chapter 9).
Entities that hold bonds, such as bond funds, exchange- traded funds (ETFs), closed-end funds, and unit investment trusts (UITs), which generally don't come due on a specific date. As a consequence, you may take a loss when you sell them. In addition, when you buy these entities, they may have up-front fees, annual management charges, other fees, and/or back-end fees when you sell them. We believe that these entities are a different animal from individual bonds (see chapter 14).
Alhough you may come to appreciate the world of bonds as much as we do, learning about bonds may seem overwhelming. It is, after all, a business that has developed over centuries. Focusing on plain-vanilla bonds will help you learn about the bonds that are the most important investments for you. However, even with plain-vanilla bonds, there are new terms to learn so you won't stand out as a greenhorn. All the terms you need to know are clearly explained in chapter 5.
Although our preference is for plain-vanilla bonds, there is a vast landscape of possible bond investments, all of which we describe in Part Three, including a full discussion of mortgage-backed securities, junk bonds, and entities that hold bonds (bond aggregators). You should understand all the different varieties of bonds so that you don't come to the conclusion that all bonds are similar and buy only the highest yielding. Bonds are generally aligned in accordance with their risks and due dates. If high returns are promised, you can be sure of high risks. There are very few undervalued bonds. If a bond looks like a bargain to you, that probably means that you're missing one or more significant facts known to the bond traders and dealers. The 100 percent bond portfolio is risk averse. Don't reach for yield and think you're safe because you invested in bonds. What you don't know or don't understand may hurt you.
There are times when risky bonds may be profitable for those willing to take the plunge. "Yesterday's weeds are being priced as today's flowers," Warren Buffett observed in 2004.[25] He was referring to the junk bond sector. In 2006, the returns from junk bonds were still not worth the risk of investing in them[26] because the interest rates on Treasury bonds rose while the interest rate on risky high-yield bonds and other risky debt including emerging-market debt continued to fall.
Since the mid-1980s, the extra yield received for investing in junk bonds over Treasury bonds has ranged between 3 percent and 10 percent on a seven-year bond. In May of 2006, junk bonds yielded about 3 percent more than similar Treasury bonds. If the spread between Treasury bonds and junk bonds is only at 3 percent, you may actually earn a lower return on a portfolio of junk bonds if one or more of them defaults, even though they pay more current interest.
If you reach for a higher yield by investing in junk bonds or emerging-market bonds, you will need substantial diversification in these asset classes to reduce the risk of a major loss to your portfolio. Chapter 16 describes how to buy bond funds to achieve the required diversification of risk. If you do invest in junk bonds, consider them as part of your risky investment category because they have characteristics more similar to equities than to the plain-vanilla bonds we recommend.
An old saw on Wall Street goes "All investors walk the line between greed and fear." Greed is ignited in part by media saturation that trumpets the news that investors who bet on the bull and give their money to the loudest advertisers in the financial services industry will become rich. Risks and fees are often understated or minimized if they're described at all. Many of today's so-called leading-edge new financial products are examples of what's called "black box" technology. Investors are not told what is in the box. Even if someone described the technology to them, they probably would not understand it. It is unclear what risks are imbedded in these new financial products and the total of the up-front, annual, and back-end fees is also cloudy. This is what happens when investors "play in someone else's game." It is understandable that investors get fearful when they contemplate these black-box investments. But even if investors, drawn by greed, overcome their fear, should they be willing to get into a game if they don't understand the rules, the degree and amount of risk, or the total cost to play?
In the complex world of new financial products, you face the conundrum: What do you do if you know that you don't know? With new financial products multiplying faster than rabbits, it's easy to conclude that you don't know enough. The real question is what to do about it? Should you just walk away from the latest financial technology purported to have the highest return? Investors struggle to decide how to sort out the unknowable financial products and decide which investment strategy is best for them. As financial advisers, we struggled with this problem for many years before we settled on the solution of the 100 percent bond portfolio invested in plain-vanilla bonds. We are fully convinced it is the best choice.
Chapter Notes