investing

The Hidden Risk of Bonds

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If I were to tell you that you could buy a bond that would pay out interest of 5% or more per year for the next 30 years, that might sound like a great deal. It’s certainly a great price in today’s interest rate environment—nearly double what 30-year U.S. Treasury bonds pay—and best of all, it lasts for 30 years. Other income may come and go, leaving you scrambling to find replacement investments that may or may not have the same yield, but this hypothetical bond will (one hopes) be around paying you the same rate for three decades. Sounds like a lead pipe cinch, right?

Wrong.

There is a catch. A 5% yield that will not go down for 30 years sounds great in today’s interest rate environment—but it is also guaranteed not to go up for the next 30 years. If interest rates rise and yields go up, your 5% bond will inevitably be left behind. If you try to hold onto your bond, your returns will look pretty pitiful compared to newer bonds that pay more interest and inflation will eat away at your purchasing power. If you try to sell your bond to hop on board higher yield issues, you’ll have to sell at a deep loss—no one will want to pay full price for your 5% bond if they can go out and buy 8% bonds instead. Either way, the damage would be considerable.

In investment terminology, this feature of bonds is known as interest-rate risk. The longer the bond maturity, the higher the risk (which is why longer term bonds pay higher interest.) Not only is it more likely that interest rates will rise at some point during the holding period, the damage will go on for longer before you get your money back at maturity.

We have many reasons to be nervous about holding on to long term bonds, even ones that have performed exceptionally well. For the past eight years, the Federal Reserve’s near-zero interest rate policy has been distorting the bond market, which is why overall bond performance looks so good in retrospect. But we believe that if it is impossible for something to continue, it won’t. Sooner or later the Fed will have to return to a sane interest rate policy, and when it does, long-term bonds are going to suffer badly.

We’ve been in this low interest bubble for so long we’ve forgotten what a realistic bond market looks like. If you find yourself scratching your head at the idea of selling off bonds that seem like a good bet, realize that what looks like a good deal now may not turn out to be so good in a few years. If you have any questions about your holdings, give us a call or email us to talk.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Volatility Versus Risk

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In the investment world, we often speak of the riskiness of an investment in terms of volatility: if an asset’s price changes rapidly and unpredictably, it tends to be spoken of as risky, and if the price tends to stay the same, it is usually regarded as “safe.”

In the short term, this is reasonable. If you have $100 today and you know that you will need $100 a week from today, the only sensible move is to put your money someplace where you know its value won’t change. Investing it in a volatile market means you might make a few extra percent your original money, at the unaffordable risk of coming up short when you actually need your money.

When we start to look at investing for the long term, though, we can start to see the difference between volatility and risk. Suppose you take your money and bury it in a hole in the ground for 30 years: this is about the least volatile “investment” you can possibly make. You can reasonably expect that the value of your buried money will stay nearly constant. Yet, because of the existence of inflation, it is almost a certainty that your money will lose a lot of purchasing power over the course of 30 years. Essentially you have a 100% chance of losing value over the long haul despite having virtually no day to day volatility.

On the other hand, if you took your money and invested it for 30 years, you can afford a lot of up and down movement during those 30 years—as long as the final value is higher than what you started with. If your investment has a daily gain 51% of the time and a corresponding daily loss 49% of the time, you can be fairly confident in your eventual profit—even though you’re watching the value go down several thousand times over the course of those three decades.

None of us know the future: there is no such thing as a guaranteed investment, and every investment incurs some form of risk. But it’s important to understand the difference between an asset’s volatility and its risk. For long-term investors, looking past day to day volatility can help you find bargains that are not as risky as you might think.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk including the loss of principal.

Organize Your Money: The Easy Way or the Hard Way

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Anyone with a passing interest in personal finance has read about the need to know where your money goes every month—to run your finances in accordance with a household budget. If you google “household budget” you will find millions of links. It turns out there is actually an easier way.

A typical budget would include line items for home expenses including utilities, telephone, insurance, property taxes, rent or mortgage payment; auto including payment, repairs, insurance, gasoline; personal items including health care, clothing, gifts, personal care, etc.; and so forth.

It takes a fair amount of time to determine what amounts should be budgeted in each category, and then to track your spending by category each month. Time is what life is made of—we should be careful how we spend it. Especially when there is an easier way. So simple, it fits in three words:

Pay. Yourself. First.

If you always save 10% of everything you ever make for the long haul, you probably will be able to retire at a decent age. PAY YOURSELF FIRST by electing that kind of percentage into employer retirement plan or other long-term investments.

If you put something into savings every payday, you’ll never get caught short by a broken appliance or unexpected home or auto repair. PAY YOURSELF FIRST by putting 5% of income into shorter-term savings. When your savings balance equals many months of income, you can transfer funds to long-term investments.

Depending on your circumstances, you may need to pay yourself more to reach your goals. But the 10% and 5% are a good place to start.

So with the ‘pay yourself first’ method, how much should you spend on everything else, all those other categories of things we need or want? Very simple: whatever is left over after you pay yourself first. Think twice about buying a money pit of any kind—it will imperil your goals. Spend as little as you need to on things that decline in value, like vehicles. And be careful about things that come with monthly bills, like pet horses or satellite TV. Housing and vehicles consume major fractions of our incomes, so make thoughtful decisions in those areas.

As long as you simply pay yourself first, you can get to where you want to go. Or you can do it the hard way: download one of those comprehensive budgets and get to work.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. Investing involves risk including the loss of principal.

Is the Market Just A Casino?

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Some people experience a lingering reluctance to invest because they suspect Wall Street is a giant casino. Most of us understand that a casino will, on average, fleece its customers of their hard-earned money. But does the market actually function like that?

In reality, a share of common stock listed on a stock exchange represents a percentage ownership interest in a large enterprise. A bond represents money loaned to an enterprise or government for the promise of stated interest and a return of the face amount on the maturity date.

Shares of a successful business or bonds issued by a solvent company tend to reward long-term holders by returning amounts in excess of the original investment. These increases may be in the form of interest on bonds or dividends on stock, plus preservation or growth of the principal invested. These kinds of investments are not like a slot machine or a roulette wheel, games rigged by casinos to pay out only a fraction of the money wagered.

The amazing thing about a share of stock is that an owner receives the same proportional benefits whether a single share or millions of shares are owned. The companies associated with Warren Buffett, Bill Gates, and the Walton family are well known to many. And anyone who wishes may invest in those companies on exactly the same basis as Buffett or Gates or
the Waltons—and enjoy the same percentage results.

(We are not recommending or advocating the purchase of any specific company to anyone, of course.)

The flawed casino analogy may seem plausible since some investors engage in short-term trading, speculation, and other aggressive tactics. But how one uses the market is within one’s control, and the practices of short-term traders have nothing to do with long term investors.

One person may use an automobile as a getaway car after bank robberies, while the next one uses a car to commute to work. The misuse of a vehicle by the robber has nothing to do with the usefulness of the vehicle to the commuter.

So for you and for us, the answer is, “NO!” the market is not a casino.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All investments involve risk and may lose value.

Is the Market Too High? A Principled View

We follow three guiding principles in our work. Avoid stampedes in the markets, find what we believe to be the biggest bargains, and seek to “own the orchard for the fruit crop.” (The orchard analogy for income-producing securities is apt, since neither crops nor dividends are guaranteed.) In this letter, we will explore how these principles apply to one question that seems to be quite common these days. The question is whether the stock market is simply “too high,” based on the move up from the panic lows of 2009.

Our first principle, avoid stampedes in the markets, is based on our understanding that the stampede is usually going the wrong way. There was a stampede into tech stocks in 1999, which ended badly. There was a stampede into real estate in the early 2000’s, which ended badly. There was a stampede into commodities after that, which ended badly. In short, major peaks are usually accompanied by a stampede of money that drives prices to extremes. Our observation is that there has been no stampede into stocks yet, no overwhelming volume of money driving prices to ridiculous levels.

Our second principle, seek the best bargains, lets us sort “the market” into its pieces. The three major asset classes are stocks, bonds, and cash alternatives. Cash and its alternatives currently earn zero-point-nothing interest rates; bonds are barely better. Diving one level deeper into stocks, we find that some sectors and industries are expensive and others appear to be bargains. For example, natural resources in most forms have seen falling prices for several years. Oil is about one-third of the 2008 price; copper is near a decade-low; the price of iron ore has been falling for four years. So stocks in the largest global natural resource companies are as low as one-third or one-fourth of the peak prices of a few years ago.

As a counterbalance to natural resource companies, we have found potential bargains among companies that benefit from low energy and resource prices: selected automakers and suppliers, airlines, trucking companies, and manufacturers. While “the market” may or may not be too high, these companies certainly do not appear to be too high.

Our third principle is to seek to own the orchard for the fruit crop. Portfolio income is an important component of total returns, and those among us who rely on our portfolios to buy groceries surely understand the importance of cash income. As noted above, interest rates remain very close to zero—we do not believe that bonds or cash alternatives are a good way to generate income these days. But we are currently enjoying generous dividends from many companies in the bargain sectors, including the oil and natural resource companies. Other holdings purchased in past years continue to pay regular dividends, from pipelines to telecom to auto stocks.

Summing up, this study of our principles leads us to say “the market” is not too high, particularly the sectors we currently own. No guarantees, of course, and past performance is no guarantee of future returns.


The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. We suggest that you discuss your specific situation with your financial advisor prior to investing. All performance referenced is historical and is no guarantee of future results.

Stock investing involves risk including loss of principal.

The payment of dividends is not guaranteed. Companies may reduce or eliminate the payment of dividends at any given time.

Investing in real estate involves special risks such as potential illiquidity and may not be suitable for all investors.

The fast price swings in commodities will result in significant volatility in an investor’s holdings.

Precious metal investing involves greater fluctuation and potential for losses.

Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise and bonds are subject to availability and change in price.

Because of its narrow focus, sector investing will be subject to greater volatility than investing more broadly across many sectors and companies.

No strategy assures success or protects against loss.