Bonds aren’t as safe as they may seem

When stock markets tank, most people think, “boy do I wish I owned bonds.”

Let me make this clear–bonds are NOT riskless. Although people perceive them as riskless, they are not! Bonds face risks from default and inflation.

Many people wish they owned bonds because U.S. Treasury bonds have done so well over the last year and a half. That doesn’t mean all bonds have done well. Junk bonds, corporate bonds, investment grade corporate bonds, municipal bonds, mortgage backed bonds, etc. have all been decimated.

To have done well with bonds during this downturn, you’d have needed to be prescient enough to know exactly which bonds to buy and no others. Very few people are that good at forecasting beforehand. Everyone is afterward–but those are profits you can’t eat.

So, what are the risks for bonds. The first risk is the same as for stocks–what you buy can become worthless. Government bonds rarely default, but rarely is not never. The second risk is inflation. Government bonds are very vulnerable to inflation risk (the exception being inflation protected bonds, but even they face inflation risk if the consumer price index differs from your cost of living increases).

How can a bond become worthless? A bond has a senior claim on a business’s assets. That means bondholders get paid before equity holders. But, that claim comes after customers and after the tax man. If a company goes bankrupt, bond holders can still be wiped out. They get paid before equity holders based on what’s left, but that doesn’t mean they will get paid back in full, and it doesn’t mean they will get paid back with certainty.

The bigger threat to bondholders is inflation. And, here, I believe stockholders are actually better off than bondholders.

Suppose you buy a 3% bond and inflation goes up. If you own a short term bond, your impact is smaller than if you own a long term bond. A short term bond can be rolled over into a higher yields as inflation goes up. A long term bond doesn’t have this luxury.

How much of an impact am I talking about? Pretty big. Suppose inflation goes up by 3% more than the market expects: the value of a 10 year bond would decline by around 20% (all things equal). A 30 year bond would decline by almost 40%! If inflation went up 6% more than people expected, then a 10 year bond would decline by 40% and a 30 year bond would decline by over 60%! If you believe bonds can’t go down like stocks, think again!

The price declines I referred to above would happen quickly, but you’d still get back your full principal at maturity, right? The problem is that those dollars will be worth a lot less than they are now. Whether you sold right away or held to maturity, higher than expected inflation will hammer long term bond holders.

That’s true for government bonds as much as any other bond. In fact, I believe government bonds are much more risky than usual now. Almost every other type of bond is trading at record high relative yields, so they are safer from inflation risk than government bonds that are at record low yields. Government bonds are extremely unlikely to default, but the dollars you’d receive may not be worth much.

Most people seem to under-estimate the risks of bonds. Default risk and inflation risk make them risky, whether people recognize it or not. Talk to anyone who owned bonds in the 1970’s, and they’ll tell you what owning bonds felt like in an inflationary and recessionary environment.

Stocks may have a lower priority claim on a business’s assets, but they do adapt to inflation better. The revenues and costs of most businesses tend to keep up with inflation over time and so do their earnings. This protects them, over the long run, from the ravages of inflation. Stocks may not do well when inflation increases, but they do very well when inflation levels off or decreases. In the long run, they protect shareholders from inflation better than bonds.

Is unexpected inflation likely? Perhaps not in the short term, but over the next 3 to 5 years, I believe high inflation is very likely, and perhaps more than the 3% or 6% I referred to above.

Stocks aren’t riskless, but neither are bonds. Stocks face more risk from default, but less risk from inflation. When government spending is expanding like never before and the Federal Reserve is printing money at a rapid pace, it’s a good time to consider inflation protection and the fact that stocks may turn out to be less risky than bonds over the long run.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

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Short term madness

The average holding period of a stock on the stock market is only 7 months.

7 MONTHS!!!

Using some back-of-the-envelope math, that means that if a mere 2.4% of trading is done by long term holders (who hold an average of 4 years), then the average holding period of the other 97.6% of people is under 6 months!

That means that when you see the price of something you’ve bought go up or down, it is because the vast majority of traders–not investors–are only looking at how a stock will “perform” over the next 6 months.

But, what happens over the next 6 months is almost entirely random. How a company will perform over the next 3 to 5 years is based on underlying data. But, focusing on how stock will “move” in the next 6 months is not investing–it’s just guessing at “price action.”

Many investors have been shaken by recent price movements, and I have been, too. But, when I consider the fact that almost all trading is done by people with a focus on the next 6 months, I start to relax and focus on the long term.

When you aren’t buying for the next 6 months–when you’re truly a long term investor–you can focus on underlying businesses, and how they will perform over the next 3, 5, 10, even 20 years.

This is the way to invest.

Don’t focus on short term price movements. Focus on the underlying business and how it will perform over the long term.

This won’t prevent short term anxiety, but it may very well allow you to focus on the phenomenal growth prospects that await investors over the next 3 to 5 years.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

What is smart money doing right now?

Investors frequently wonder what the “smart money” is doing. Who or what is smart money?

Smart money usually refers to big investors who got that way by generating high investing returns over a long period of time. That doesn’t necessarily mean big money.

A lot of money is managed by large organizations that didn’t necessarily get that way from smart investing. Think about a large pension fund or insurance company. Those organizations have a lot of money because a lot of money has been contributed to them (pension contributions and insurance premiums), not necessarily because they’ve managed it well. Big money is not the same as smart money.

Smart money has a lot of money because they’ve compounded initial investments at high rates for a sustained amount of time. Smart money moves into and out of markets before they move, not after or as they are moving. Smart money includes the “lead bulls” that the rest of the herd follows. Knowing what the smart money is doing can help build wealth because you can buy before things move.

This last reason is why everyone, including me, wonders what the smart money is doing.

So, what is the smart money doing now? I don’t know exactly, but I have an idea.

For example, a lot of smart money is still on the sidelines–in cash. It’s not there because they sold at the top or because they were timing the market. It was in cash because the smart money has been waiting for opportunities, waiting for years most likely.

Why haven’t they started buying? They have, but very selectively. Remember, smart money buys before things move, so you can’t look at price movements to see what they are doing. They are buying things on the cheap, at prices they can only get once every two or three decades, but they are taking their time.

Why are they taking their time? That’s the most important question, and I think I have an answer. They’re taking their time because the rules have changed. When the rules change, you have to wait for new rules before you can act.

What new rules am I talking about? Let me use banking as an example. It used to be that bad banks went out of business and good banks thrived. But recently, bad banks have been deemed “too big to fail,” and so they have been kept alive. Keeping them alive hurts good banks, and so the smart money is waiting for the new rules to invest. They don’t want to invest in good banks only to find out the new rules will hurt the good for the benefit of the bad.

The same could be said for distressed debt investing. Whether a company survives or not has less to do with assets, liabilities, cash flows and business model, currently. Instead, it has as much to do with number of employees and perception. Look at U.S. car companies. No one cried when Circuit City or Pilgrims Pride declared bankruptcy, but if a U.S. car company is in trouble, it doesn’t need to go bankrupt. The rules have changed, and the smart money doesn’t want to invest until they know those news rules.

I think the key reason markets haven’t been improving is because the rules have changed, and the smart money is waiting to learn those new rules. When those rules are made clear, then the smart money and, eventually, everyone else, will jump back into the pool. Market values are cheap enough, whether equity, debt or real estate. I don’t believe the smart money is waiting for markets to get cheaper, they are waiting to discover the new rules of the game.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.

The investing world’s Holy Grail

Archimedes once said that he could move the world with a large enough lever and a place to stand. Like Archimedes, I think I could “move the world” by dramatically improving investors’ returns–if I could just eliminate their desire to time the market.

I don’t believe there is anything that destroys long term investment returns as much as the desire to time the market. It is the investing world’s Holy Grail–it doesn’t exist, but people keep trying to find it anyway.

Every investor seems to wish he could sell at “the top” and buy at “the bottom.” Very few consider whether this feat is possible with anything other than hindsight. If investors would consider this seriously, perhaps their returns would improve dramatically.

The stories investors hear about someone who supposedly sold at “the top” and bought back at “the bottom” seems to egg them on. Like feats of ESP, this supposed achievement is frequently sited but infrequently submitted to rigorous study.

Remember, even a broken clock is right twice a day. So, if someone repeats over and over again that the market is going to drop, at some point they will be right. Same with the market rallying. This is not a demonstration of skill, but that a broken clock can be right.

Have you ever examined the Forbes 400 list of richest people? Check it out some time, and look for the market timers. You won’t find a single one. In fact, the guy topping the list, Warren Buffett, says timing the market is not possible. Take his advice, seek not the Holy Grail.

The investors who build wealth over the long run do it by PRICING, not TIMING. They figure out something is cheap and they buy it. They don’t panic when it becomes cheaper, because they know what it’s worth. They usually buy more.

Those who try to time the market end up guessing about market tops and bottoms, because such things can only be seen clearly in hindsight. They almost always end up buying high and selling low.

Look at the statistics on investor versus mutual fund returns. Mutual fund returns are anywhere from 4% to 8% higher than the returns investors get. Why? Because most investors, in their search for the Holy Grail, sell what’s not “working” and buy what is “working.” They almost always sell something that is about to take off and buy something that’s about to tank.

I’m not saying people don’t get lucky every once in a while and sell at the top or buy at the bottom. What I’m saying is such luck should be associated with winning the lottery or getting struck by lightning, not with a sound approach to reaching your financial goals.

Don’t seek the Holy Grail. Buy when things are cheap and accept that they will almost certainly get cheaper. Buy more if it gets cheaper. Rinse and repeat. In 5 to 10 years, you’ll be very happy you didn’t pursue the investing world’s Holy Grail.

Nothing in this blog should be considered investment, financial, tax, or legal advice. The opinions, estimates and projections contained herein are subject to change without notice. Information throughout this blog has been obtained from sources believed to be accurate and reliable, but such accuracy cannot be guaranteed.