A lot of people find bonds confusing and make the common mistake to think that individual bonds and bank certificates of deposit are safer than bond funds. Here is a book about investing for beginner and intermediate investors that explains it all in plain English.
Rick is on his virtual book tour for his new book, Why Bother With Bonds, and sits down for an interview with Jennifer Howell. Hear how he answers her hardball questions 😉
JENNIFER: I’m Jennifer Howell and today I’m talking with Rick Van Ness. His new book, “Why Bother With Bonds,” is about how to build an all-weather investment portfolio and why it should include CDs, Bonds, or Bond funds. There are many pictures and illustrations. The target audience is ordinary investors (usually beginners)—like me.
JENNIFER: Rick, thank you so much for sitting down with me.
RICK: Thanks for having me.
JENNIFER: This past week, the stock market has set new record high levels. What is an all-weather portfolio, and why should bonds be a part of that?
RICK: Our problem is that we never know what will happen in the future. As an investor, your risk is not having the amount of money you need when you need it. Most of us are not going to achieve our financial goals by saving money and stuffing it under our mattresses. We need to rely on the growth of stocks over long time periods to achieve those big long-term goals, but it is bonds that controls risk. Otherwise, we would all put all of our money into the stock market which has higher expected returns, but also very high volatility.
JENNIFER: The title of your book is provocative: Why Bother With Bonds. Is it actually about why we need to include bonds?
RICK: Yes! My book highlights four reasons: Stocks are risky, Bonds make risk more palatable, Bonds can be a safe bet, and bonds are an attractive diversifier. But we could simplify it further and say that it is all about risk—controlling risk.
For instance, if you will soon need your money for a house down payment, you pretty intuitively know better than to invest that money in the stock market—which could drop 50% any year.
JENNIFER: OK, so I should invest in bonds. Where should I start?
RICK: I like to say there are two things that are important. Your most important habit is to save a portion of every paycheck.
The second thing isn’t a habit but rather a decision. It is this asset allocation. First: how much in stocks and how much in bonds. This is where you set the risk in your portfolio.
JENNIFER: Interest rates have been really low for a long time now. Does that make investors reluctant to invest in bonds?
RICK: Well, two things to know are that people cannot predict future interest rates any better than they can predict the stock market—which they cannot—and second, that an increase in interest rate is not necessarily a bad thing for bond holders.
You are highlighting a problem we call market timing. Investors like you describe want to be in the investment de jour—the investment that is currently outperforming the others. This week they are probably wishing they were in 100% stocks with no bonds. But these investors often overestimate their predictive skills and risk tolerance. They buy when stocks are hot, they flee to the safety of bonds after stocks tumble. They don’t do as well as they could with a simpler common sense strategy.
JENNIFER: I know that when interest rates go up, bond prices go down. But why do bonds seem more confusing than stocks? People get all tripped up on how they are affected by interest rates so I’m glad you have many examples in your book.
RICK: Yes, and that’s ironic because bonds are much simpler than stocks. It’s the goal of my book to help you see this. Stocks can change in a day what bonds might change in a year. There are a thousand things that effect the price of stocks. Bonds are very simple. You loan your money, the bond is a promise to return your money on a particular date and meanwhile pay you an interest rate for the use of your money. So a bond is like a simple loan.
JENNIFER: So, if you believe interest rates will go up would it be smart to wait?
RICK: Let me ask you . . . With a CD, you are going to get that $1,000 back in a year, plus all the interest payments. In fact, you are going to get exactly what you signed up for today with no surprises. Not one! Suppose you know you’ll need that money in 1 year. Where is the appropriate place to invest it? In a CD (which is a special form of a bond) or in the stock market?
JENNIFER: OK. That’s the idea of matching when I need the cash with when my bond matures. How does it work with a bond fund that doesn’t have a maturity date?
RICK: It sounds like you get it. Now a bond fund is just a collection of individual bonds but it is far more convenient for most people. Now, here’s the part I want you to remember. You can have a fund of short-term bonds, or a fund of long-term bonds. Either way, if you hold the fund for longer than its duration after an interest rate rise, then you still come out ahead! Because the bond fund is constantly re-investing at this new higher interest rate.
JENNIFER: Yes this was in your book. Your diagrams were very helpful. You also make the case to buy only U.S. Treasuries and very high quality bonds.
RICK: Yes—the argument is that it’s better to control your risk with the correct amount of bonds – US Treasuries – and to keep your investment risk in the stock market. The simple explanation is that junk bonds are more correlated with the stock market so those bonds can go south at exactly the wrong time!
JENNIFER: For stock investments, I always hear how important it is to diversify. Is it any different for bonds?
RICK: For most people that’s just fine. They’ll end up with a Total Bond Market Index Fund which is predominantly US Treasury Bonds. But if you understand a little more you’ll see the differences. I have bought the argument that it is smarter to stick with the very highest quality bonds—U.S. Treasuries, FDIC-insured CDs, and TIPS which are bonds where the principal grows with inflation. I explain several reasons for this strategy I the book, but you probably appreciate that bonds backed by the U.S. government are as good as it gets, so you can’t reduce credit risk any further by diversifying.
JENNIFER: So, you control risk by allocating your investments between stocks and bonds. How do you figure what percentage to put in bonds?
RICK: First, we are investors, not speculators, not gamblers. Let’s separate money we need in the short-term, because the stock market can literally lose 50% of its value in any year.
We all have many goals, but by far the biggest – for most of us – is to finance our retirement. When you are in your 20s this can be predominantly stocks. When you are in your 80s this might be predominantly bonds. How you change every year is a rich area for discussion but the percentage doesn’t matter as much as having a simple plan and sticking to it.
JENNIFER: Thank you. I like your examples of this in your book. I have one last question. You volunteer your time teaching about common sense investing. Why do you do that?
RICK: I’m actually very attracted to the idea of living frugally and thereby capturing the freedom to use your time as you want—to wake up every morning to make a contribution, or to just savor the precious moments we have on this planet. But, that’s the stuff of another interview.
JENNIFER: We’ll look forward to that. Meanwhile, good luck with your new book.
RICK: Thank you!