30 Day Investing Challenge, Day 14: Know What A Bond Is
Another common asset investors sometimes choose to add to their portfolio are bonds. Bonds are a fixed-income asset that represent a loan made by an investor (lender) to a borrower, with repayment terms and everything. The borrowers are usually corporations or governments, which use bonds to fund projects, and the lenders are any investor, including individuals like you and me. Bond terms include when the principle of the loan is due to the lender and the details of the borrower’s variable or fixed interest payments. The way you make money on bonds is through the interest rate and by getting your principle back at the end of the bond’s term. You can also resell the bond to other investors at a higher price.
The safest bonds are government, specifically at the federal level. Corporations can go bankrupt, which means you’d lose all the money invested in that corporate bond. But you’re pretty safe with the federal government borrowing money from you. If they go under then you have waaaayyyy bigger problems than not getting your bond money back.
There are many different types of bonds, too many to list here (I referenced I-Bonds on day 11 when talking about medium term goals). But my favorite are bond index funds, specifically total bond market index funds. These cover a broad sector of the bond market, so you’re not putting all your eggs in one basket.
Pros & Cons of Owning Bonds
Pros:
You get income from the interest payments
You can make a profit if you resell the bond at a higher price
It creates a steadier portfolio that’s less reactive to market ups and downs
Cons:
Bonds have pretty low returns, so you won’t make as much money over time than if you went all in on stocks
If you buy a company bond they can default on the loan and you won’t get any of the money back
Bond yields can fall over time so you get a lower interest rate
Why I Don’t Have Bonds
I don’t watch the stock market regularly. This means I don’t really care how much my portfolio is dropping or rising on a day to day basis. Even when early Covid hit and my portfolio plummeted with the rest of the market, I didn’t bat an eye. This is why I don’t need bonds. Bonds “smooth the ride” as J.L. Collins says in his book The Simple Path to Wealth, which means they make the ups and downs of the market flatter over time. But this also means you’ll make less money over the long term. The graph below shows how 100% stock, 100% bond, and 60/40 stock/bond split portfolios perform over time:*
As you can see, the 100% bond portfolio performed dismally over a 40 year period. The 60/40 stock/bond split didn’t do too bad, and definitely helped investors keep their blood pressure down during large dips. But overall the 100% stock portfolio performed the best.
If you have the stomach for it, meaning you won’t panic sell if the market crashes 50% in one day (which theoretically could happen, but hasn’t yet), then I say go all in on stocks and make the most money you can. But if you’re like 95% of all other investors who have a heart attack when they see their portfolio plummet, then mix in some bonds. I mean, it’s fair: if you had $1 million invested and in one day it went down to $500k that would be AWFUL! Luckily the largest one day drop in history was only 22.6% — this was Black Monday in 1987. We’ll talk about asset allocation, meaning how much you should invest in stocks, bonds, and cash, in an upcoming challenge, so sit tight!
Action Step: Study A Bond or Bond Fund
Pick an interesting looking bond or bond fund (if you’re stuck try Vanguard’s total bond market index fund, VBTLX)
Look over its return history over the last 1 year, 3 years, 5 years, and 10 years (if applicable)
Notice the ups and downs. What was its highest point? What was its lowest point? What was the spread between the two (meaning what was the highest point minus the lowest point)? Write all this down.
And lastly, write down the total return of the bond or bond fund over at least one decade — if there’s return information that goes beyond a decade write down the return for the longest period of time up to 40 years. What do you notice about this number? Is it high, is it low? If you got this return, how would you feel given inflation averages 2-4%/year?
Come back tomorrow for your next challenge: knowing what an index fund is.
*Reference: R. B. Matthews and Doug McCutcheon, Longview Asset Management Ltd.
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