What are the advantages of holding bonds?

We have seen in this post what bonds are. However have you asked yourself what are the advantages of holding bonds. We are going to have a look at the different uses of bonds for the average investor.

1. Safety investment

One of the most important uses of bonds for the average investor especially in this recession is to secure your portfolio. Investors who anticipates a bear market, turmoil in the stock market or a recession  might not want or have the courage to watch their portfolio’s value fluctuate widely. As a result in anticipation they will want to sell their investment and flee to the safest investment. Some will invest in treasury bonds, treasury bills, high quality corporate bond or money market mutual funds. After the events the investors can sell these safe assets and then reconstitute their portfolio. 

2. To maintain the value of the portfolio

The first use of bonds for the average investor is to maintain the value of the portfolio. Most bonds can be said to be quite safe especially if you invest in government bonds and investment grade corporate bonds. Because bonds are issued at a discount and then redeemed at face value the investor is certain that he will obtain more than he invested initially. Furthermore some bonds will pay coupons twice a year. So even if the return on bonds are small, the investor is assured to end up with more that he started with. If you invest in treasury inflation protected securities then your principal will be adjusted so that you will not be hurt by inflation. thus your return will always be greater than inflation.

3. Diversification

Diversification a strategy whereby you invest in a range of securities and in various sectors so that they will not be affected equally. If your portfolio is equally diversified it is possible that some of them will increase in value while while some of them will decrease in value thereby offsetting each other. Bonds are the best asset to hedge against stocks. As you the value of stocks increases and decreases while that of bonds will remain the same. Hence when the stock market is down the presence of bonds will reduces the loss of value of the portfolio. Now when the stock market is up the percentage of stocks in the portfolio increases as a result to keep the value of bonds in the portfolio constant you will have to rebalance. You will thus sell stocks to buy bonds. This will ensure that you lock the gain in stock market by buying bonds.

4. Fixed income generation

Some people, especially retirees need a regular source of income. Because bonds pay regular coupon every six months a portfolio that has a sufficient number of bonds in it will provide income to the retiree on a regular basis. Stocks on the other hand pay dividends but it is not compulsory for companies to pay dividends so an investors that have stocks in his portfolio is not certain of receiving dividends on a regular basis. However since on the long run the stock market rises then the investor is sure that the value of his stocks will increase with time.

As you can see it is very important to have a certain percentage of you money invested in bonds for the presence of bonds will help to stabilise your portfolio. 20 % for the aggressive investor up to 40 % for the prudent investor is an appropriate allocation. However make sure that your bonds are sufficiently diversified ranging from safe government bonds to slightly yieldy corporate bonds. If you are adventurous you can invest in municipal bonds.

Strategies for the successful investor part 7 : Performance obsession

Many investors are obsessed by performance in that they are always on the alerts for tips, hot stocks or emerging sectors of the economy. These investors always want to be on board of the latest bull market. They always want to buy at the lowest price and sell at the highest price.

However what investors need to know is that assets are mostly cyclical and that their ups and down do not takes place at the same time. Hence while one sector of the economy is down another sector will be down. Hence if you invest too heavily in one sector or in one asset then if their is a downturn or a bull market then you will be too exposed to that sector and as a result your portfolio will be adversely affected and you might lose heavily.

The way to go is to be exposed be a wide variety of assets such that when one asset lose value the decrease will be offset by an increase in the value of another asset. Hence if you are exposed to a wide variety of asset classes you will have your eggs in the same basket. In case their is a loss in one type of assets then it will only be a small part of your portfolio.

Hence the way to go is to through heavy indexing of the market. You will need to be exposed to a wide range of index fund and mutual fund. You will invest in bond fund, mutual fund in stocks, etc.

Hence when you will invest in index fund and mutual fund you will not have the need to chase performance. You will be exposed to every sectors of the economy and all this will be done passively. Hence  you will not need to chase performance. Your return will be close to that of the overall market.