Bonds or fixed income securities are basically IOUs issued by companies or the government that pay a certain amount of interest each year and the full principal amount at a certain known date in the future. By their very nature, fixed income securities pay a fixed rate of interest that today, depending upon maturity and quality, is only a few points above the inflation rate. Because your goal of building wealth involves beating the rate of inflation by a significant amount, fixed income securities are not powerful tools. However, if your goal is to reduce risk and maintain your principal instead of maximizing its growth, then fixed income securities may be just the thing for you.
Many investors think that the price of a bond stays constant while it pays its interest. This is not the case. In fact, bond prices fluctuate more than people know. Most bondholders only get a chance once a month (on their brokerage statements) to see the prices of their bonds, as opposed to the prices of stocks and mutual funds, which are printed daily in the paper.
- What makes a bond fluctuate? Interest rates. When interest rates rise, bond prices fall, and when interest rates fall, bond prices rise.
- When is the best time to own a bond? When interest rates go down.
Otherwise, bonds are not powerful wealth-building tools because they don’t produce enough of a return in the long run, relative to stocks.
One prevalent conventional theory is important to understand. If you haven’t heard it yet or read it somewhere, you will. Some people believe that an investor should have a percentage of his portfolio that is equal to his age invested in bonds. If the investor is 20 years old, then 20 percent of the portfolio should be in bonds. If the investor is 80, then 80 percent of the portfolio should be in bonds. What a bunch of garbage! The percentage of bonds in a portfolio shouldn’t have anything to do with the age of the investor.
Everyone has her own individual goal and risk tolerance. A portfolio’s bond allocation should be based upon an individual’s risk tolerance and interest rate forecast, not the age of the investor.