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Money Matters

STOCK OR BONDS? HOW DO YOUR DECIDE?

By MARY LYNNE DAHL, CFP®

 

November 09, 2018
Friday PM


jpg Money Matters by Mary Lynn Dahl

Mary Lynn Dahl

(SitNews) Ketchikan, Alaska - For years the accepted norm for investment of a portfolio was to allocate more to stocks and less to bonds at younger ages and then gradually reverse the percentages as one got older. Generally, a person in his/her twenties or thirties would be told to have 70% to 80% in stocks and 30% to 20% in bonds. The reason for this percentage mix was that stocks offer more potential for growth while bonds offer more potential for income. In addition, stocks were viewed as riskier than bonds. Usually, older investors seek income to replace earnings when they retire, so the gradual switch from stocks to bonds, targeting a mix of 30%-20% in stocks and 70% - 80% in bonds made sense for many people.

There was a lot of truth in these assumptions, such as stocks having more growth potential than bonds, but particularly that bonds offered more income and were less risky than stocks, but today, that has been shown not to be the case. Today, bonds have as much and sometimes more risk attached to them than many stocks and frequently pay less in interest income than stocks pay in dividend income. Why is this true? What has changed?

For one thing, bonds in the past were pretty straightforward and simple. New bonds are sold at “par”, which is a unit of $100 or $1,000. A bond is a loan made by an investor, to a corporation or government agency, paid back over time, with interest. The longer the payback period, the higher interest rate the bond would pay. For example, a bond that matured in 5 years might pay 5% interest but a bond with a 10 year maturity date could pay 6.5% interest. The reason that longer term bonds paid more interest is that there is more risk that interest rates will change over 10 years than over 5 years, and if rates do change, the change will be greater over the longer period of time than over the shorter period of time. Changing interest rates make the bond worth more or less than the investor originally paid for it, so there is risk of loss of principal when this happens to a bond. Bonds in the past were rated for risk with an A, B C and F rating system that anyone could understand. Most bond investors in days past simply held their bonds to maturity and accepted whatever interest rate they got.

Today, however, bonds have morphed. They are no longer simple. They can be straightforward government or corporate bonds, but they can also be a packaged mix of all kinds of exotic loans based on multiple layers of investors who are betting (literally) on various outcomes of different strategies that no one fully understands. This is not traditional investing and these are not traditional bonds. The fact that they make up a significant part of the bond market today adds a layer of risk that would have been unthinkable decades ago. This kind of risk is more difficult to identify and define, so bond investors need to be far more savvy and alert to bond risks than in the past. Risky bonds are referred to as “junk bonds”, for a reason, and pay higher interest rates, as incentive to offset the risk they carry. High quality bonds with less risk pay lower interest rates.

Bonds have traditionally been used in a portfolio to create income, especially for a retired person wanting to get a check every month starting at retirement. This was a typical and common way to fund retirement for many people. For example, an investor would invest $100,000 in a portfolio of 10 year bonds paying 6% interest and know that she/he would get a check every month for $500. It was easy and simple, and if the bond was high quality, there was little risk of default or loss of principal.

Today, it is possible to get only about 2.5% - 3% on a high quality government bond, but for most portfolios, this is not enough. In particular, when a retiree reaches age 70 ½ years of age, he/she is required by the IRS to take a minimum annual distribution (RMD)of at least 4%. This percentage goes up as the retiree ages, so it will climb to 5% and 6% and higher as the years go by. If the bond portfolio only produces 3% in interest, it will not be enough. That means that the retiree will have to take the rest out of principal. Eroding principal is the wrong thing to do with a retirement account, until reaching a very old age, such as 85 or 90, because of the risk of outliving your money. People are living to much older ages today, and can, in fact, run out of money if they spend down the principal of a portfolio that is supposed to produce income on which to live indefinitely.

The impact of rising prices (inflation at the consumer level) is a big risk to anyone facing or in retirement. A bond portfolio that cannot keep up with rising prices dooms the investor to ever decreasing purchasing power. I have heard numerous comments at social gatherings from retirees who say “My money doesn’t buy nearly as much as it used to buy and my budget is very tight”. If inflation is 2% per year (less than the historical norm) and you need $50,000 in income today, you will need $67,300 in 15 years and $82,000 in 25 years, just to keep up with the rise in prices. This is due to inflation doing what it has always done, erode the value of the dollars you have. If you are trying to live on bond interst, fully or partially, be prepared to make budget cuts as the years go by. Your dollars will not buy as much in the future as they do today; you can count on that!

By comparison, there are a lot of stocks today that pay dividends of 3% and more. Stocks that pay these nice dividends are often very stable corporations, big companies with excellent financial strength. In addition stocks have the potential for capital appreciation, meaning that shares of a stock can increase in value. For example, you may start out with stocks valued at $100,000 and watch them double in value in only 10 years if they grow in value by the average stock market return of 7.2% per year. In this case, you will have protection from the damage to your income that results from inflation.

Stocks can drop in value too, so there is always that risk, but bonds can drop in value as well, despite the label of safety that bonds have always incorrectly enjoyed. If you paid $1,000 for a bond a few years ago that pays 2.5% and need to sell it today, you will not get your $1,000 back; you will get less because the buyer can buy a brand new bond today that pays more than 2.5%, making your bond worth less than a new bond. There is not much growth potential in a bond when interest rates are on the rise, as they are today. The only time bonds increase in value is when we are in a long term cycle of falling interest rates.

Based on all of these facts, there is a shift in investment strategy on the part of many professional advisors and savvy investors to hold more stocks and fewer bonds in a retirement or long term portfolio. The theory is that today, a portfolio needs more growth potential than bonds can produce, to offset the long term impact of inflation, and to satisfy the required minimum distribution (RMD) rule imposed by the IRS, making stocks a better way to produce that income. Because stocks can produce both dividend income and growth in share value, they offer more ways to produce income and protect the portfolio from losses due to spending down principal and eroding of purchasing power due to inflation. We note, however, that in the future, if and when the US enters a cycle of high interest rates, our strategy would likely be more open to bonds than now. This is a cycle that has repeated itself in the past, so we acknowledge it is possible that it will do so again in the future, at some point.

This paradigm shift in thinking is sound. I have been offering this opinion for several years that a retiree consider a portfolio mix of far more in stocks and far less in bonds than was the old, traditional 30%-70% rule of thumb. There are good reasons to believe this is the best way to protect a portfolio, reduce interest rate risk, avoid loss of bond principal and position the portfolio for increased income potential over the long term. A 20-30 year view is typical for most retirees, given that many of us will surprise ourselves and live to a very old age. You need to be adequately prepared for that possibility.

If you are comfortable during retirement, never run out of money and end up leaving some behind, consider yourself fortunate . If you are lucky enough to have leftovers, leave it to family, or to charity, or to an organization that you feel could benefit greatly from a legacy gift. Do some smart retirement planning, leaving a little for someone else, and consider your financial life a success!

 

 

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©2018 Mary Lynne Dahl, CFP® is a Certified Financial Planner ™ and partner in Otter Creek Partners, a fee-only registered investment advisor firm in Ketchikan, Alaska. These articles are generic in nature, are accepted general guidelines for investment or financial planning and are for educational purposes only.

Mary Lynne Dahl©2018

Mary Lynn Dahl can be reached at moneymatters@sitnews.us

 

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