Where Should You Put Your Money?
- Aug 23, 2010
- admin
- Investing
IT’S OFFICIAL: SMALL INVESTORS ARE LEAVING THE PARTY.
According to the Investment Company Institute, a mutual fund industry trade group, through the first seven months of the year investors have withdrawn a “staggering” $33.12 billion from domestic stock mutual funds.
$33.12 billion is a big number, no doubt. That means small investors are selling stocks in droves because they fear more pain. Since nobody – especially folks coming close to retirement – wants to keep seeing the value of their portfolio decline this move makes some sense.
But what doesn’t make sense is where all this money is going: according to the Investment Company Institute, it’s going into government bonds.
Why is this troubling?
Because U.S. government bonds are about as overvalued as the housing market was in 2006. It’s just a bubble waiting to pop. And you don’t want to be anywhere near it when it finally does.
Let me explain:
Let’s say you buy 5-year U.S. government bonds paying 3% annually. The bonds have a face value of $1,000. Since you have $10,000 to invest you purchase ten of these bonds at $1,000 each.
That means that in exchange for lending the U.S. government $10,000 for five years you get $300 in interest each year, tax free. At the end of the five years you get your $10,000 back in addition to the $1,500 in interest you’ve collected ($300 x five years = $1,500).
Now the key to understanding bonds is to understand that there is an inverse relationship between bond prices and interest rates. It’s easy to visualize if you look at it like it’s a “see-saw” relationship –
If interest rates go higher bond prices go lower. If interest rates go lower bond prices go higher.
Now what does that mean in the real world? Let’s take the $1,000 bond from the example above to illustrate.
To make math simple let’s say that every time interest rates rise by 1% the price of the bond will decline by $100. So if, during the next three years, interest rates rise by 3% the price of each five-year bond will decline by around $300.
That means that the $10,000 invested would decline by $3,000, making the $10,000 investment worth $7,000.
Of course, the key here is interest rates. If you believe, as I do, that the net effect of the U.S. governments policy of printing money by the boatload will be inflation in the next few years then bonds probably don’t make a great long-term investment.
What does that mean for these investors buying U.S. government bonds?
It means that many of them are likely to experience some serious financial pain – especially if the bonds they are buying are long-term bonds.
Why? Because the longer it takes for a bond to mature (it’s “duration”) the bigger the impact interest rates have on the price.
For example, if interest rates rise a bond that matures in one year will decline less in price then a bond that matures in five years.
So what’s an investor to do?
If you have to move money from stocks to bonds here’s two suggestions:
(1) Don’t buy bonds that mature in more then three years;
(2) Make sure that whatever money you invest in the bonds you don’t need until they mature because if you’re forced to sell them early it is very likely you’ll sell them at a loss. I make these suggestions because I’d hate to see folks who were hurt investing in the stock market get hurt investing in bonds, especially if they don’t understand all of the risks (since few “professionals” understand bonds it’s unlikely your broker will explain the risks accurately to you).
Of course, if you happen to believe that the FED’s multi-trillion campaign to prop up the housing market and the economy will not lead to inflation then this article will be of little use to you.
But keep in mind that you’re betting against history on this one and that’s just not a bet I’d recommend making.
You are what you read.
Dylan Jovine