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Bonds Are Insurance Against Short-Term Risks Of Stocks

How was your Thanksgiving?

Hopefully, you enjoyed some good food and drink with friends and family.

Perhaps, the bigger question: How's your Black Friday going?

Me?

I steer well clear of retail establishments and malls on this particular Friday each year. But if you're going to be out there - or are already out there - good luck.

And I can't believe I even have to say this, but please stay safe.

If you've been following my writing for a while, you've read my thoughts on the importance of bonds (aka fixed income) in your portfolio.

That's why I have bonds in my portfolio, too.

Here are a couple of past articles on bonds:

  • Here's a February 2017 article I wrote on bonds as Portfolio Insurance​
  • Back in March 2015 I wrote about When, not if, Interest Rates Rise​
  • And I've written about and addressed bonds elsewhere

Another great article on bond investing comes from my friend and fellow advisor, Sam Bass. Back in 2010, Sam wrote a great piece on what many considered an investing "bubble" in US Treasury bonds.

And that was almost 10 years ago now.

Bottom line: it's important to own high-quality bonds as part of a diversified investment portfolio. I believe one of the best ways to do this is through an exchange-traded fund that invests in 7-10 year US Treasury bonds. Again, these are the very bonds I own in my own portfolio.

But, while bonds have historically been less volatile than stocks in the short term, they are not without risks.

Chief among these risks are rising interest rates.

As interest rates rise, bond prices typically go down.

The reason for this is pretty simple: if you own a bond that pays 2% interest and rates go up, so you can now get a similar bond that pays 3% interest, well the 2% bond is no longer as attractive to invest in.

As a result, its price falls.

This might be an oversimplification, but it conveys the basics of why bond prices and interest rates move in opposite directions most of the time.

Looking back over the past couple of decades, bonds have been a great investment. Of course, we only know this in hindsight.

And it's no coincidence that interest rates are at historic lows based on how we've seen bonds perform.

But what happens when rates rise?

I consider bonds to be like insurance against the short-term risks of stocks. Or instead, consider them like a stock market shock absorber.

But what if - for whatever reason - interest rates start going up?

What if they go up sharply?

I'd like to call your attention to another article about bonds - this one from Cullen Roche of Pragmatic Capitalism.

Whether you're one of my clients and own bonds, or you're doing something on your own or with another advisor, I really encourage you to read Cullen's article.

I think the article speaks for itself, but basically it says that while bonds will likely suffer short-term price declines in a rising rate environment, over time (based on historical data) they are likely to produce a positive return.

Of course, past performance is no indication of future results.

But you knew that already.

An important element highlighted in this article is that as rates rise, bonds pay more interest. If you own bonds via a mutual fund or exchange-traded fund (my personal preference), the bonds in your fund will, over time, also pay a higher interest rate.

This higher interest rate you could receive from your bonds accrues to your benefit over time.

I could go on, but I'll spare you.

Just know that the best investment portfolio for you is the one you can invest in and stick with over long periods of time through good markets and bad.

And in my opinion, the best way to build such a portfolio is a combination of owning virtually every stock around the globe alongside some high quality US Treasury bonds of intermediate maturities.

While bonds aren't immune from risk, given time - and more importantly, patience - high-quality bonds have done okay even in the midst of what could be considered a worst-case scenario.

And if you have any questions about any of the above or any of the articles I've linked to, don't hesitate to let me know.

P.S. - Retirement is a big shift for most people. Not only does your paycheck go away, but you're also faced with how to fill 8+ hours a day you spent working.