Balance among types of investment is as important as the balance among individual stocks and bonds. Just as individual companies and investments may do better or worse, various areas of the economy may also fare well or poorly. This is why asset allocation is vitally important.
Of course, you prefer for all of your investments to strike gold, but that doesn’t happen for even the savviest among us. Instead, we have to plan for the occasional hiccup in our portfolios.
In other words, we must diversify. By balancing among different types of investment, different durations of investment, and different weighting of risk and reward, we attempt to maximize the money coming in while protecting ourselves from the inevitable ups and downs of individual investments and markets.
This strategy is known as diversification, and it is familiar to most of us. We look for the balance that comes from dividing our investments between stocks and bonds or between big companies and small ones. Indeed, how we should diversify is basic to the debate among major investors and financial advisors as they look at investment theories.
The opportunities available for balancing your investments and guarding against the volatility of markets go far deeper than most people realize. This is one key reason for working with a CERTIFIED FINANCIAL PLANNER™; these professionals understand the many ways an investment program can be out of balance, and they know how to bring that balance back.
The two major areas of investing are fixed income and equity. Equity investments give you some ownership of the company or companies you’re investing in, and we will discuss them in our next post. Today we look at fixed income investing, where you are literally lending money to a company, government or other entity.
When you choose fixed-income investments such as bonds, certificates of deposit, and money market accounts, you know going in what you are supposed to be paid and when. Historically, these investments are less volatile than stocks (i.e., less likely to go bad), but they’re not all sure things. Some are riskier than others, and your return will reflect this risk.
The two major distinctions within fixed-income investments are quality (i.e., the likelihood you’ll get paid as planned) and duration (how long it takes to get paid).
Bonds are rated by agencies such as Moody’s or Standard & Poor’s based on the bond issuer’s perceived ability to meet its obligations. The ratings go from “AAA” at the highest and move down the alphabet, much like grades on a report card.
Let’s say you’re looking at a municipal bond, and your choices are between New York City and Ty Ty, a little town in my home state of Georgia. New York, because of its size and wealth, should be able to meet its obligations even during bad times. It will have a high rating. Ty Ty, on the other hand, could be hit hard. with setbacks ranging from an economic downturn to a natural disaster. It is less able to guarantee that its bonds will get paid back, therefore the rating is lower.
As your advisors, we don’t tell you to stay away from higher-risk bonds; after all, with higher risk comes higher potential payback. But we sometimes ask you not to put all your eggs in one high-risk basket. If you decide to put your money in high-risk bonds, spread it around.
As you might imagine, the longer your investment’s duration, the more sensitive you are to changing interest rates. For instance, we are currently in a time of rising interest rates; that means shorter durations are better, all other things being equal. It would be frustrating to buy a three-year bond today when you could get double the interest rate this time next year. When you work with a CFP®, you have someone to help you anticipate the economic weather. The rising and falling of interest rates is one example, but there are many others. For instance, government policy can affect your return in the energy sector. The Obama administration made it clear they believed the country should move away from coal-fired power plants. Whatever your personal feelings toward energy and environmental policy, factor these pronouncements into your investing decisions.
Similar considerations come into play throughout the investing world, as long as you know how to look for them. If you do know how to look for them, your investing experience is likely to be much happier.