Any suggestions and illustrations in this blog are not intended as financial advice. They are my personal opinions.
I heard the following on a TV and radio broadcast last week on a day the stock market dropped significantly, and the bond market increased. I did not take notes, so this is not an exact quote, but the sense of it is pretty much what was said.
“What happened today highlights the reason why people should diversify a stock portfolio with longer-term bonds. The bond increases offset some of the stock losses since bonds typically increase in value when the stock market decreases. This way, they maintain part of the value of their portfolio.”
That is what I heard. Does it sound familiar? Now think about what it says.
I find this naïve, incorrect, misleading, amateurish, and illogical! Here are my reasons:
My 15 Reasons Why
- There are two broad types of investors: traders and long-term investors. If you are familiar with what I post, you will know that I do not provide any comments for traders. That is their occupation and their focus is making a living. Good luck to them. Long-term investors should have as their focus attaining certain long-term goals and securing their eventual financial security, usually a very long-term goal.
- The focus of news commentators is to say things their viewers and listeners would find interesting and would want to continue listening to their reports. That usually means they have to not only say something different but do it in an interesting way and perhaps have the viewers learn from them or even act on it.
- Acting on news, rapidly changing market activity or something heard on a TV broadcast is usually impulsive and counterproductive to the deliberation of a long-term strategy. I am not saying you shouldn’t listen to them, and if you hear something that makes sense to you, then you should consider integrating it into your long-term investment strategy as long as it is aligned with your goals and everything else you employ when setting those goals and the way to implement a strategy to get you there.
- Markets change frequently and continuously. They go up and down and rarely are static. There are also many ways to invest. I try to simplify it by suggesting two major methods.
- A well-diversified stock portfolio and;
- a laddered long-term bond portfolio.
- I suggest stocks for time horizons of at least seven years and I am suggesting bonds for a period of three to seven years. I am not prescient and suggest these periods based on my experience and how I see things right now. My suggestions change but my “at least seven years” for stocks has not changed since I have been making my recommendations. The bond terms have changed based on the spread in rates over the periods. Right now, and for the more recent past, I have been going with shorter terms of three to seven years. This is a change to a more conservative period for the bonds. The ladder idea works quite well, and that should also be considered.
- I have made a considerable change in my recommendation for a rainy-day fund. I increased the size from 6 months to 3 years. Pre-COVID, I was suggesting a 6-month cash fund for contingencies and sudden changes in your situation. I have extended that to 3 years. This is a substantial change, so I will explain it. This is cash that is available for any unplanned contingency that would extend over an uncertain time period, such as the Covid lockdown, huge and quick market drops, a job loss, significant health change or a family emergency needing sudden cash. Six months always seemed to work but the Covid lockdown created widespread uncertainty, business closings and product shortages. Anyone with excess cash during the beginning of that period certainly felt more comfortable than those without cash or who needed to sell stocks to raise some needed cash. Perhaps three years is an overreaction, but the feelings of uncertainty are reduced when you are sitting on a cash hoard. However, this is an individual choice, and each person should make their own decision. Further, I do not feel this fund should be included in your asset allocation of your investments. It should be separate from that. However, these funds can be invested in money market funds, treasury securities or bank certificates of deposits.
- Here is where I explain rainy day funds: First-Time Stock Market Investors’ 5-Step Model - Withum. I also explained laddering the investments in that post.
- Other than investing to acquire cash for a specific purpose, people should invest to be able to attain a targeted cash flow at some point in their lives. The sources of cash flow would be stock dividends and money market, bank CDs, treasury bills or bonds and municipal or corporate bonds. These are referred to as “fixed income” investments.
- It has been my experience that people who invest in fixed income are not investing to grow the asset values but to acquire interest income. If they do not need to spend the interest, then it could be used to acquire additional fixed-income investments until such time that they would need to spend the interest. The longer that period, the more they would accumulate, and with the magic of compounding, their portfolio would grow, as would their interest.
- I believe that many people who do not invest in the stock market consider it risky and choose the fixed income to avoid the risk of losing what they have. Another reason, and a good reason, is the higher interest that is paid versus the stock dividends. So they avoid risk and receive greater cash flow. This is not a bad reason to invest in bonds. However, there is a logical inconsistency to this.
- Premise of bonds #1: It is a fixed-income investment primarily to provide interest income to the investor and is considered risk-free.
- Premise #2: If bonds are considered risk-free, then how come they fluctuate in value so much that the news commentators mentioned that “gains” from bonds were an offset to the stock losses?
- Reality of Premise #1: If the people who invest in bonds fully intend to hold them until maturity and are able to, and if the issuer of the bonds does not default on them, then the bonds are risk-free, and they will be redeemed in full at maturity. Note that there are continuous market-driven fluctuations but those should not affect the amount redeemed at maturity. As a comment, there are many other market risks that are inherent in any investment, such as inflation and interest rate risks, and those are not considered in this context.
- Reality of Premise #2: Fluctuations are only meaningful if the bonds need to be sold before maturity and then the values would matter. However, this should not affect the long-term investor intending to and able to hold the bonds until maturity. Therefore, when a news commentator says the gains in value are a balance against the stock losses, that is a spurious comment. It just ain’t so!
- The realities of the two premises become a reality for anyone who owns a bond fund since there is no maturity date and eventually when the fund shares are sold, there will be no redemption at face,but the amount received will be based on the market value of the funds at that time. That is a risky investment. But that is not the situation when you own individual bonds.
- On some level, the changes in stock values in a long-term portfolio are somewhat immune to the continuous fluctuations in value since the expectations are that they will be owned long enough to recover from any market losses. But any losses from a down market sure will upset the investors.
Final Thoughts
There is a lot more that I could write about that quoted verse, and about investment allocations in particular. However, I believe the above indicates that that quote is what I attributed it as being. Also, this is a warning that you should understand fully what you are investing in and how you could make money and lose money, and how the cash flow works. Furthermore, if you use a financial advisor make sure they explain it so you are fully clear about what you are investing in. And make sure everything you are told is logical.
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