Stocks or Bonds?
What to do? Pam explains where to invest NOW!
You can’t keep all your hard-earned money in a savings or money market account because money market and savings accounts pay zero interest. You certainly can’t trust all your serious money to the stock market even if it has behaved better over the past few weeks, because you can’t trust Wall Street! Real estate is completely unreliable these days, and the price of gold is already so high – how high can gold really go? And gold is just too esoteric. So what’s left – - bonds or mutual funds that invest in bonds? Well, it’s where billions and billions of investors’ money is heading. Out of stock funds and straight into bond funds.
The latest consumer confidence figures were released earlier this week from Reuters and the University of Michigan. The survey results show everyday working Americans are feeling – - DOWN about about the economy and they believe things are getting worse not better. With the unemployment rate stuck at just over 10%, American consumers (who account for as much as 70% of the all our economic activity), say they are tapped out. With that mood in mind, the investing public is on a stampede out of stocks and stock mutual funds in order to protect and preserve what little savings they have. They believe they are playing it safe by loading up on bond funds which are presumed to be much safer investments. Well guess what? There are lots of ways you can lose money in bonds and bond funds even though these appear to be designed for your grandmother.
Bonds have always been considered a way to one’s overall reduce risk when investing, because when you own a bond or mutual fund full of bonds, your motivation is simply to collect the interest the bond pays. You invest your funds knowing you will get a better – higher rate, say 5% in a high yield bond fund versus .25% from your bank. And… at the same time, you get to sleep at night! What a deal! Here’s what you absolutely need to know now: There are lots and lots of different kinds of bonds and no matter which you choose, there are two major risks you need to know about before you sell all your stocks to bet the farm on bonds.
BONDS HAVE RISKS
Credit risk: You think you are making a safe bet investing in high yield bond funds – these are also called junk bond funds because the companies selling the bonds to you are not in good financial shape. Hint: that’s why they have really low credit ratings. These companies are businesses and often desperate to raise to cash and therefore willing to pay you very high interest if you loan them the needed cash. But these same companies are often closer to the edge of bankruptcy than you or I will ever know. They can simply stop paying you the promised interest at anytime. What to do if that happens? You would only have once choice – sell your bond. That brings us to risk #2.
Interest rate risk: Risk number two – You believe your investment in bonds is a stable one because all you have to do is hold onto your bond and one day in the future, you’ll get your money back and you’ll earn interest all those years. And yes, I’m including US Gov’t Treasury bonds in this scenereo. Say that guaranteed 30-year treasury bond pays 3.8% interest – - again, it’s better than your savings account at zero percent. Here’s the problem though. Five years pass and interest rates begin trending up. Now your bank savings account is advertising 5% interest. But you’re stuck holding onto your 30-year treasury bond that’s STILL only paying today’s (old) interest rate of say 3.8%. Remember, that 3.8% rate is FIXED. Now all of a sudden, your safe gov’t bond looks pretty unappealing compared to that nice 5% you could have gotten on your savings at the bank. At that point, you’ll be itching to ditch the US gov’t treasury bond way before the maturity date in.. ah.. 2040! I don’t ‘know about you, but I’ll be 80 then! Therefore, you will discover when you go to bail out of that lousy 3.8% treasury early, your “risk-free” gov’t treasury is not worth what you paid for it. Yes, hold it until 2040, and you will get your full investment back but you’ll never earn more than 3.8% a year. In other words, the value of that 3% bond has dropped and if you do sell the treasury before 2040, and rates stay higher than 3.8% – you’ll take a loss and wipe out all the interest you would have earned.
So what to do?
- Don’t follow the crowd. I know you want to, so do I. It’s human nature. But the fact is, when the crowd runs away from the stock market, that’s the very time to shop for value in the market. That’s how great investors make money.
- Try not invest any money out of FEAR. If you are living paycheck to paycheck, work on shoring up your savings account. Even though you cannot invest that money, keep enough of a supply in cash so you’re covered without needing to run to credit cards. if you’re a typical family earning $50k a year, go ahead and keep $15k on tap “just in case.” That cash won’t earn much interest, but it will be available so you can sleep at night.
- Take some of the money you can afford to invest and spread that out over the broad stock market through a low cost index fund.
- Do invest some portion into bonds keeping in mind the risks – especially with interest rates at rock bottom cuz the last thing you want to do is unknowingly park your serious money in something you thought was a sure thing. Keep in mind, over an investing lifetime, stocks have outperformed all other investments.
To answer the question… “should I invest in bonds or stocks?” The short answer is: yes. Both, because it’s the combination that works best.
Who Likes the Stock Market?
The latest consumer confidence figures were just released from Reuters and the University of Michigan and the stock market immediately dropped. The confidence survey results suggest that everyday working Americans are feeling down about about the economy and they believe things are getting worse not better. With the unemployment rate stuck at just over 10%, consumers who account for as much as 70% of the all our economic activity, say they feel tapped out. This last confidence report reflects all that collective pessimism. I mean look at the evidence that supports this view, the housing market is still so unstable, the government cannot seem to stop spending money or get it’s act together and make a firm decision about future tax policy that affects each and every one of us. The fact is, the investing public is on a stampede out of stocks and stock mutual funds and believe they are playing it safe by flocking into bond funds which are presumed to be much safer investments. Well guess what? There are lots of ways you can lose money in bonds and bond funds even though these appear to be designed for your grandmother.
Is it any wonder that anybody who might be in a position to invest in stocks is not seeing this as a screaming buying opportunity? Well, maybe he or she should.
Is the sky really falling or is this a screaming buy signal for great stocks of good solid companies that have loads and loads of free cash flow but their share prices are beaten down. Everybody knows that when the crowd runs away from the market, that’s the time to shop for value in the market. We know it but we don’t do anything about it. We wait until the crowd’s back and when half the movie theater’s full, that’s when we decide to follow and go looking for seats. But we never seem to grab the best seats in time because… well… we follow. Plain and simple, that’s not how great investors make money.
I know, I know… stock market performance (S&P) has been underwhelming over the past couple of years, or the past five or ten years for that matter. Consider though that long term thinking has paid off through good times and bad. From 1960-2009, stocks measured up with 9.4% compared to 6.6% for bonds. But over the past decade, it’s been the exact opposite with total returns on bonds at 6.3% on average and stocks doing absolutely nothing – - meaning losing money after factoring in inflation. But back to my original question – isn’t this even more reason to consider buying into the market?
Ned Davis Research Inc. in Venice, Florida, studied returns for the Dow Jones Industrial Average when confidence as measured by the Conference Board survey is high, medium and low and the biggest gains happen when confidence is at the lowest point. So maybe now is a good time to read or re-read a great article by John Dorfman that he wrote (way) back in August about the relationship between overall confidence and taking advantage of that consumer sentiment and revisit the whole notion of long-term thinking.
I can tell you that when my 21 year old nephew starts asking me where he should invest his long-term savings, I’m going to suggest the tried and true conservative approach that includes a hefty percentage of his hard earned money invested in the broad market because now he has an opportunity to make a profit. Of course, dollar cost averaging is still the best approach.
If you want a quick primer about why you need to invest, just click here for MSN Money’s New Investor Center!
The Bush Tax Cuts
Don’t Just Stand there and do nothing!
THE UNCERTAINTY AROUND FUTURE TAX RATES IS BAD FOR ECONOMY, BAD FOR INVESTORS AND EVERYONE IN GENERAL.
Bush Tax Cuts We keep hearing about the “Bush tax cuts” that could go away in January 2011. These tax breaks were enacted in 2001 and 2003 during George W.’s first term in office. Congress and the President have known for months that unless these tax breaks are extended beyond that deadline, they will automatically end January 1st. For the next month and a half, this conversation is going to get louder and louder. You’ll hear experts argue how the Bush tax cuts provided a much needed boost to the US economy over the last decade and that allowing them to lapse is equal to a tax hike for everybody- the Obama tax hike and the biggest in our history. But other economists and politicians are saying we are only taking in roughly $2 trillion in tax revenue but spending more than $3 trillion this year. In other words, spending more than we make. So the argument goes, as a country we simply cannot afford to continue giving away such big tax breaks to the richest taxpayers. So who’s right and how will you be affected once this issue is settled? To simplify and clarify the whole thing, the Bush tax breaks have benefited every level of income whether you’re a married teacher with two kids, a retired investor or you own a baseball team. Right now, the president says he intends to preserve the tax breaks already in place for everyone EXCEPT individuals who make more than $200k a year or families making more than $250k. This group of tax paying Americans represents less than five percent of the population and does include some small business owners who file as individuals. At this moment there’s a lot of yakking going on about introducing brand new tax credits to help small businesses – but as the clock ticks down toward the December 31st deadline, its just alot of talk. Meantime, we sit in limbo-land and everyday investors, mom and pop business owners, and CEO’s are stuck in the mud and unable to make any meaningful financial decisions about adding employees, paying overtime, renting office space or selling shares of Apple stock because nobody knows what’s going to happen to their tax bill if they do. Families with estates worth over $1 million are wondering when grandma should be taken off life support because if she dies in 2010 there’s no inheritance tax at all but in 2011 55 percent will go another close relative- Uncle Sam! unless the government does something to permanently extend Bush’s breaks here’s how you will be affected.
If The Bush Tax Breaks Expire, What Will Happen?
- Higher Marginal tax rates on personal income: Bottom line – less take home pay. The rate at which you pay your taxes is going to go up. Currently, the lowest federal income tax bracket is just 10%. Without the Bush tax breaks, that will slide up and you’ll owe 15% of your income. So if the Bush cuts were allowed to expire, a married couple making $50k a year will owe about $850 more in taxes. President Obama’s plan is not to allow those breaks to disappear. The married couple making $250k will owe another $9,000 if the cuts expire.
- Parents with Children: For those who qualify, the $1,000 child tax credit would be cut in half to $500.
- Married Couples: The Marriage Tax Penalty would return – meaning that filing as a married couple costs you more than if you filed as a single.
- Higher Taxes for Investors: Taxes on capital gains and dividends – Those in the top brackets will pay higher rates on long term capital gains and the taxes you have to pay on dividends you get from any of your investments. Right now the highest rate you pay on any dividends is capped at just 15% thanks to the Bush tax cuts but that rate could become as high as 39.6%. That’s a big difference. Capital gains tax on investments held for more than one year will also go up – but not as much. From 15% to 20%.
- Higher Federal Estate Taxes: right now there is no estate tax but as of 2011, there will be a 55% tax on estates worth more than $1 million.
So where does this issue stand?
At this moment it appears the President wants to preserve the Bush breaks except for the highest earners. Now I keep hearing the words “temporary extensions” cropping up and I hope that congress isn’t going to take the lazy way out of this. Let’s face the music and deal with this whole dysfunctional tax system we have and make some real policy changes. I’d almost rather have a little bad news than no news at all. At least that way, I can make my own plans.
Will small business owners be hurt if the Bush breaks end?
Small business owners who make more than $200k will be affected. Let’s take, for instance, a sole proprietor who runs an accounting business from her home. Her taxable income might be just over $200k. That’s her business profit and without the tax breaks – - she’ll have to pay an extra $10k of that profit to taxes. Maybe that’s the money she might have otherwise invested to expand her business, rent office space or take on a couple of employees.
Will this kill job creation?
This is a big part of the on-going argument. The reality is, is, in this country, small businesses, especially brand new start up’s contribute substantially to job creation but it’s also true that most of the mom and pop businesses are not finding themselves in the highest tax brackets so most small business owners would not be directly affected in the financial sense. Higher taxes don’t do much to incentivize entrepreneurs though. Meanwhile, this uncertainty is keeping the economy from moving ahead.