Seeking Certainty
WE WANT OUR STOCKS to behave like bonds, and our bonds to behave like cash investments. That leads to all kinds of portfolio contortions—some of them damaging to our investment results.
Remember, risk is the price we pay to earn higher returns. Many folks want those higher returns, but they’re anxious to avoid risk. Chalk it up to loss aversion: We get far more pain from losses than pleasure from gains.
Result? Think about stock-market strategies like purchasing equity-indexed annuities and writing covered call options. Equity-indexed annuities capture part of the market’s upside while guaranteeing against losses—assuming the buyer owns the annuity for long enough. Meanwhile, writing call options allows folks to collect extra income in the form of option premiums, providing a small buffer against market declines, but the price is a cap on potential stock-market gains.
As investors look to limit losses, however, the biggest portfolio contortions tend to revolve around bonds, not stocks. The strategies employed typically involve favoring individual bonds over bond funds, and then holding those bonds to maturity. This can add a fair amount of complexity, especially if folks build elaborate bond ladders, with each rung designed to cover a particular year’s spending.
No doubt about it, there’s some reward for this complexity. If we buy an individual bond and hold it until it matures, we know exactly how much interest we’ll receive each year and how much we’ll get back upon maturity. Sound appealing? My advice: Before buying into the notion that bond funds are riskier than individual bonds, and that holding individual bonds to maturity eliminates risk, we should ask ourselves four questions:
Bailing early. Where’s the certainty if life intervenes, as it often does, and we’re compelled to sell our individual bonds before maturity? How easy will it be to sell the bonds in the secondary market, and could we receive far less than the bond’s par value?
Worrying about pennies. If we’re willing to own stocks and run the risk of steep short-term losses, should we really get hot and bothered because we don’t know precisely what a bond fund will be worth when we’ll need our money back in, say, 10 years?
No safety in numbers. Are we really reducing our financial peril if we trade the diversification of bond funds for the single-issuer risk of an individual bond? Is the added risk involved worth it, given that the return of an intermediate bond fund will likely be similar to that of an intermediate individual bond of comparable credit quality?
Losing to inflation. Where’s the certainty in knowing that each of our individual bonds will be worth $1,000 upon maturity, but we have no idea what the purchasing power of that $1,000 will be?
To be sure, the risk of individual securities is reduced if we stick with Treasury bonds, which most experts believe carry scant risk of default. Worried about inflation? That can be addressed with inflation-indexed Treasurys and Series I savings bonds.
Still, I’ve never owned an individual bond, except a $75 EE savings bond I won for finishing second in a 5k road race. Why not? I’m not that concerned that my bond funds might be worth a few percent more or less than I’d hoped when it’s time to cash out. Why would I? Heck, I’ve lived through two 50%-plus stock market declines during my investing career, so modest fluctuations in bond prices hardly seem worth the worry.
Meanwhile, I simply don’t want the hassle and complexity of dealing with individual bonds, including Treasurys and savings bonds, and I sure don’t want to bequeath that sort of portfolio to my family. Given all the complaints I’ve read about dealing with TreasuryDirect, and especially cashing in Series I and EE savings bonds, I’m glad I made that choice.
But many readers, I know, strongly disagree.
Jonathan Clements is the founder and editor of HumbleDollar. Follow him on X @ClementsMoney and on Facebook, and check out his earlier posts.
Remember, risk is the price we pay to earn higher returns. Many folks want those higher returns, but they’re anxious to avoid risk. Chalk it up to loss aversion: We get far more pain from losses than pleasure from gains.
Result? Think about stock-market strategies like purchasing equity-indexed annuities and writing covered call options. Equity-indexed annuities capture part of the market’s upside while guaranteeing against losses—assuming the buyer owns the annuity for long enough. Meanwhile, writing call options allows folks to collect extra income in the form of option premiums, providing a small buffer against market declines, but the price is a cap on potential stock-market gains.
As investors look to limit losses, however, the biggest portfolio contortions tend to revolve around bonds, not stocks. The strategies employed typically involve favoring individual bonds over bond funds, and then holding those bonds to maturity. This can add a fair amount of complexity, especially if folks build elaborate bond ladders, with each rung designed to cover a particular year’s spending.
No doubt about it, there’s some reward for this complexity. If we buy an individual bond and hold it until it matures, we know exactly how much interest we’ll receive each year and how much we’ll get back upon maturity. Sound appealing? My advice: Before buying into the notion that bond funds are riskier than individual bonds, and that holding individual bonds to maturity eliminates risk, we should ask ourselves four questions:
Bailing early. Where’s the certainty if life intervenes, as it often does, and we’re compelled to sell our individual bonds before maturity? How easy will it be to sell the bonds in the secondary market, and could we receive far less than the bond’s par value?
Worrying about pennies. If we’re willing to own stocks and run the risk of steep short-term losses, should we really get hot and bothered because we don’t know precisely what a bond fund will be worth when we’ll need our money back in, say, 10 years?
No safety in numbers. Are we really reducing our financial peril if we trade the diversification of bond funds for the single-issuer risk of an individual bond? Is the added risk involved worth it, given that the return of an intermediate bond fund will likely be similar to that of an intermediate individual bond of comparable credit quality?
Losing to inflation. Where’s the certainty in knowing that each of our individual bonds will be worth $1,000 upon maturity, but we have no idea what the purchasing power of that $1,000 will be?
To be sure, the risk of individual securities is reduced if we stick with Treasury bonds, which most experts believe carry scant risk of default. Worried about inflation? That can be addressed with inflation-indexed Treasurys and Series I savings bonds.
Still, I’ve never owned an individual bond, except a $75 EE savings bond I won for finishing second in a 5k road race. Why not? I’m not that concerned that my bond funds might be worth a few percent more or less than I’d hoped when it’s time to cash out. Why would I? Heck, I’ve lived through two 50%-plus stock market declines during my investing career, so modest fluctuations in bond prices hardly seem worth the worry.
Meanwhile, I simply don’t want the hassle and complexity of dealing with individual bonds, including Treasurys and savings bonds, and I sure don’t want to bequeath that sort of portfolio to my family. Given all the complaints I’ve read about dealing with TreasuryDirect, and especially cashing in Series I and EE savings bonds, I’m glad I made that choice.
But many readers, I know, strongly disagree.
Jonathan Clements is the founder and editor of HumbleDollar. Follow him on X @ClementsMoney and on Facebook, and check out his earlier posts.The post Seeking Certainty appeared first on HumbleDollar.
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