MBA Course: Investing & Portfolio Management-Class 2

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BONDS

Categories: investing, mutual funds, bonds

“The social object of skilled investment should be to defeat the dark forces of time and ignorance which envelope our future” John Maynard Keynes

One of the foremost economists of the last century succinctly states a reason to invest. Learn the simple principles of investing through this MBA series taken directly from the graduate course I’m teaching in Investing & Portfolio Management. Don’t be intimidated, grasp important investment concepts in an easy to understand format.

After reading this article you will gain a useable investing skill.

As I mentioned previously, please follow these steps before beginning any investment program.

Main Topic: What are BONDS & do I need them?

Last class we talked about risk versus reward. In investing, the greater the risk, the more opportunity for reward or a high return.  Risk means that your investment is going to go up and down in value; with higher risk investments  exhibiting greater volatility.

 A BOND is a loan to a corporation, municipality, or government. When you buy a bond you are making a loan to the bond issuer. In exchange for the loan, you receive an interest payment. The amount of interest you are paid is directly related to amount of risk you are taking. (The interest in bonds is called a coupon payment).

Buy a corporate bond from a corporation with financial troubles, you get a high interest rate because if that company goes bankrupt, you might lose all of your initial investment.

Buy a U.S. government bond, you get lower interest rate, because your money is invested with a secure government who will pay you back your original investment when the bond matures.

A government bond is the safest bond to buy; it also has the lowest interest rate. Riskier bonds pay higher interest rates.

Here’s why you need bonds:

Jose is 33 years old, married, with term life insurance, 6 months cash in a savings account, and pays off his credit card bill in full every month. Three years ago, he and his wife invested in 2 index mutual funds:

1. Vanguard total stock market index (VTSMX)
2. Vanguard total international stock index (VGTSX)

He believed that since these 2 funds held lots of different companies from various parts of the world, he was sufficiently diversified and did not need any other investments.

 Look what happened to the value of his investment portfolio from 2007-present.

 What if he added BONDS to the portfolio 3 years ago? 

 Notice, with no bonds, Jose’s portfolio LOST 8.97% over 3 years; with bonds, his portfolio lost only 3.45%.

PRACTICAL APPLICATION: What is the takeaway?

• Investing is only for money needed in 5 years or more, because in the short term, the returns are volatile. These last 3 years prove that point.
• As long term returns of stocks and bonds are almost always positive and greater than returns in savings accounts, these investments are beneficial for generating long term wealth.
• Combine bonds, stocks, and some cash to an investment portfolio to lower risk (volatility).
• A combination of stocks, bonds, and cash will likely beat the investment returns over a cash savings account over the long term.

Why invest at all, the 3 year returns were NEGATIVE?

• Historically long term returns for stocks are about 9%, bonds near 5%, and cash in the low single digits.
• Combine the three assets, reduce risk, and increase returns over cash alone.
• Invest in mutual funds to simplify. No need to pick individual stocks or bonds.
• Although 3 year returns were negative, had Jose continued to invest monthly, instead of just once at the beginning of the 3 year period, his returns would have been higher.
• It is highly likely that in 10 years and longer, his investment value will be much greater. 

Caveat: This article is for information purposes only and may not be appropriate for your individual situation.

ACTION STEP:

Get a notebook and label it: “(your name) Personal Finance” and keep it by the computer. Use it to keep all of your personal finance goals, thoughts, activities, and plans.

Learn more about bond investing at Money Chimp. 

Yakezie Short Carnival: Personal Finance Lessons Learned from Bambi @ Personal Finance Firewall;  The Cost of Making your House a Home; Average Spend in your First Year of Home Ownership @ Frugal  Confessions; Post Transaction Marketing; Helpful Links or Ripoff @ The Millionaire Nurse