How to Invest for Safety

There are many ways to invest and you need to understand all the tools at your disposal in order to invest safely and wisely. In this article Steve McDonald explores an area of the market that has been ignored in recent years but should be better understood by investors today in order to protect their portfolios. -- editor

Safety First – What 25 Years in the Markets Have Taught Me

By Steve McDonald

When things get really bad in the market, I like to look back at the almost 19 years I have spent carving a living out of it. It helps me ignore the panic.

There was a time when people talked about something other than the stock market. The market was considered taboo for most. Too risky. Too foreign. The generation of the Great Depression put their money in the bank. Some still kept it in cans buried under the front porch.

In the early eighties something totally new appeared on the investing horizon: the IRA. Life has never been the same.

It seems impossible that they have been around for less than 25 years. But, there was a time when people didn’t invest in mutual funds, stocks or options. IRA’s changed all that.

For the first time in the history of the markets the average guy had enough long-term money to venture into stocks, the sacred land of the gurus. There was an explosion of investors who poured their money into areas they knew almost nothing about. The result was stock market averages sky rocketing to levels unimaginable to even the most optimistic.

2,000 on the Dow – earth shattering. 3,000 – in the stratosphere. 14,000 plus? You would have been laughed off Wall Street for even suggesting it.

I clearly remember the day the Dow Jones Industrial Average broke 5,000. We cheered. And we worried about what was coming next. This couldn’t possibly continue!

These 25 years of the investment explosion have had good and bad results.

The people on Wall Street, and those who work for Wall Street firms, have made more money than even they could have imagined. The average guy is another story.

Sure, it looks great as the averages fly and the talking heads marvel at the huge gains, but for a hundred reasons, the average guy has come up with a big zero.

As the markets tumble from the latest debacle (this is the sixth I have witnessed) an aging U.S. population is crying for relief. We are looking for something safer than stocks, but certainly offering more reward than the 3% you might get from a bank. For most, the losses are getting to be too much to put up with the stock market lottery anymore.

Consider bonds…

long ignored as too boring, not enough action or for older folks only. Perhaps these things are true. But there is a whole lot more security in bonds, with almost none of the downside of the stock market and most of the return.

As the cry has gone out for safer investments, more and more investors are pulling back from the fast track and finally making consistent returns in the safety of bonds. 

The secret to making money in investments is not to give any back. That’s what bonds do; you keep a whole lot more of your gains than you do in stocks. And it adds up.

The biggest problem with bonds isn’t their security. Investment grade bonds default around one half of one per cent of the time, or a default rate of .5 out of 100. That’s very secure.

The biggest problem is that most people know less about bonds than they do about stocks. There is less information readily available. It’s a different language, and bonds have been out of favor with investors for a long time.

But, as the population ages and has less time for their stock portfolios to recover from the latest Wall Street disaster, bonds will regain prominence as the investment of choice. The baby boomers will make it so.

We have been getting away with our love affair with stocks because we have had enough time to recover from the downside of the market cycles. But, as the boomers reach retirement, and the “almost boomers” (like myself) approach retirement, we have to seek investments that aren’t coughing us up every 18 months. We will not have the time recover our losses in our investments before we have to start living on them.

Bonds are really very easy to understand but you need to stick with a few hard and fast rules.

- Quality, quality, quality

- Do not be a rate pig

- Do not buy a bond you can’t hold until maturity

- Ladder your portfolio

- Stay diversified

Since the early 90’s, I have been preaching the gospel of bonds. But no one wanted to listen. The allure of the stock market lottery was too great. Times have changed.

Over the next few articles I will be helping you develop your bond IQ. It’s a bit of a learning curve, but not difficult. While this series is not intended to make you a bond expert, it will give you a foundation on which to build a reliable, predictable and safe investment portfolio.

Once you give your money away, it’s gone forever. Let see if we can stop some of the losses.

Editor's Note-- Bonds are not the perfect one size fits all investment (but then nothing is) bonds do have their advantages and disadvantages the key is to understand how they work. Once you do bonds can be a great advantage because you can lock in many of the unknowns that you can't with stocks.  The major disadvantage of bonds is that in times of inflation they are "fixed dollar investments" meaning that you get back a certain number of dollars which could lose purchasing power during times of high inflation.

But in times of uncertainty (like now) getting a fixed certain number of dollars back definitely beats losing an unspecified percentage of your investment in stocks. 

Bonds guarantee you a certain number of dollars at the end of the term of the bond and a fixed interest rate over the life of the bond. (Imagine knowing the dividend  the stock will pay for the next ten years and the stock price ten years from now and you can see how valuable that might be.) The value of the bond will fluctuate over the life of the bond but at least you can be certain of its value at some definite point in the future. This is much more than can be said for stocks.  And during times of falling interest rates they can be much more profitable than stocks (since their interim value goes up as interest rates go down). So bonds should definitely be one tool in your investing toolbox. 

Many investment advisors say you should have a percentage of your portfolio equal to your age invested in safe investments like high quality bonds. For example a 50 year old would have 50% of his portfolio in bonds while a 75 year old would have 75% in bonds.  That way if he needs the money it will be there even if the market is down. And by "laddering" (selecting the proper maturities of the bonds) he will always have some maturing at any given time so the money is not subject to market conditions.  -- Tim McMahon, editor