Balancing With Bonds

Question of the week:With the stock market so volatile lately, I'm considering bonds. I've never invested in them before, so can you give me some guidance to get started? --GT

Dear GT,

As you know, two of the basic investment choices are stocks and bonds. Stocks offer you the best long-term growth potential, while bonds give your portfolio some stability. It's the classic tradeoff between risk and return, and the trick is determining what proportion of each is right for your situation.

In general, I believe that most investors who have time horizons of at least five to ten years can afford to be completely in stocks--unless they just can't stomach the volatility that an all-stock portfolio has these days. In that case, a small percentage of bonds will help a good bit in smoothing out those swings.

Here's how one member of the Armchair Millionaire community uses bonds for balance:

"I've always had a couple of balanced mutual funds that were each about 30 percent bonds, so my overall portfolio has been 10-15 percent bonds for the last five years or so. It helped a lot over the last three years. I have friends who have lost three-fourths of their portfolios because they were entirely in aggressive growth mutual funds. I haven't experienced anything like that kind of loss." --IMF

If you decide that bonds are right for you, my guide will give you a quick introduction to the subject.

The Armchair Millionaire Guide to Bonds

• The basics. When you buy a bond, you receive periodic interest payments over the life of the bond. When it matures (maturities range all the way from one day to 30 years), you'll receive the face value of the bond back. The actual return on your investment is called the yield.

• Types. Bonds fall into three major categories:
  • Treasury bonds (and bills and notes), are issued by the U.S. government and backed up by its full faith and credit--you never have to worry about the U.S. not paying you back if you buy some of its bonds.
  • Municipal bonds are issued by state and local governments and are attractive because their interest is exempt from federal and sometimes state and local income tax.
  • Corporate bonds are issued by companies. These bonds usually offer higher yields than other types because there is generally more risk involved--companies are more likely to run into financial problems than the federal or local governments.

• Risks. Bonds are not necessarily the "safe" investment that many people assume. They do carry risks, some kinds much more than others. Here are some of the risks inherent in bond investing:
  • Inflation risk. Inflation can erode a bond's value over time. Bonds with the longest maturities are the most subject to inflation risk.
  • Interest rate risk. When interest rates go up or down, the prices of bonds are directly affected.
  • Market risk. Bonds follow the laws of supply and demand just like any other investment, and their prices can rise and fall accordingly.
  • Credit risk. Aside from U.S. Treasury bonds, there is always a risk that the issuer of a bond may fail to repay its debt. Two well-known companies--Standard & Poor's and Moody's--rate the credit of most bond issuers, so you can have a clear idea in advance of their creditworthiness.

• Where to buy. You can buy government bonds directly from the U.S. Treasury, or you can buy bonds of all kinds through many brokers, including most online brokers. If you want to own bonds but don't want the hassle of buying and selling them yourself, there is also a wide range of bond mutual funds available.

THE BOTTOM LINE: For long-range growth, you can't top stocks, so keep your portfolio tilted in that direction as much as you possibly can. When you need a little balance, or are getting closer to needing the money in your portfolio, add a small portion of bonds.