Competition for your dollars creates an inertia that always seems to lead Wall Street down the path of unhelpfully increasing the risk in your portfolio. The recent Wall Street Journal headline, “Bond Funds Turn Up Risk,” illustrates an especially alarming trend. Specifically, of increasing the risk in the part of your portfolio that should be reducing overall risk—bonds.
Bonds are supposed to be boring. The primary role they serve in our portfolios is not necessarily to make money, but to dampen the volatility that is an inevitable byproduct of the real moneymakers—stocks.
Yes, interest rates are low. Yes, it’s frustrating. Yes, it’s tempting to reach for higher yields in fixed income investments. But there is a price to be paid for that decision, as we saw last December when there was a run on high-yield “junk” bond funds.
Wall Street has capitalized on low-yield frustration by articulating the “problem” while claiming to have manufactured the “solution.” It’s Sales 101. But the potential gain in higher returns (from corporate bonds, junk bonds, international bonds and dividend-oriented stocks) isn’t worth the excess risk taken.
Here are four ways to ensure you’re not getting fooled, and to help you eke out a bit more interest without additional risk:
1) Take the Gut Check Test to better understand how much risk you’re really willing to take. Then take that level of risk where you’re better rewarded for it—in equities, not fixed income that comes with a shinier wrapper.
(The preceding test should not be considered a replacement for a deeper risk-tolerance analysis with a knowledgeable financial adviser. But you will get a better reading from it if you translate the listed percentages to the actual dollar amounts represented in your portfolio.)
2) Ensure you only have the highest-quality, lowest-credit-risk fixed income securities. Remember, bonds should be boring. Look for U.S. Treasurys and/or FDIC-insured CDs.
3) Lower expenses to the greatest degree possible. This is good advice whether you’re investing in stocks or bonds, but it’s especially important in the latter case because interest rates are currently so low. A best-case scenario is to create a ladder of individual fixed-income securities, completely eliminating mutual fund expenses. But, if you lack the knowledge or access to do so, look instead for index-oriented mutual funds, not actively managed funds (which can also increase the risk in your portfolio without your even knowing).
4) Increase interest rates by looking at CDs over Treasurys. My colleague, Larry Swedroe, noted in a recent article that “the yield on five-year Treasurys was just 1.23%. CDs of the same maturity were available with a yield of 1.85%. That’s an improvement of 0.62 percentage points. For 10-year CDs, the gap was even greater, with 10-year Treasurys yielding 1.7% and 10-year CDs available with a yield of 2.4%, or 0.7 percentage points higher.”
What is the ultimate goal of investing? Most answer, “To make money.” But I dispute that conclusion. In my view, the goal of investing is to have a better life, and that means understanding the stress that comes from unnecessary risk-taking. The goal of investing in stocks is to make money. But the goal of investing in bonds is to help us weather the inevitable periods of volatility inherent in equity investing. Don’t get fooled into believing otherwise.
This commentary originally appeared August 27 on Forbes.com
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