My new clients Sarah and Mark had done only a little investing. “Sometimes we think we understand stocks and bonds,” Sarah said.”Usually we don’t,” said Mark. I suggested we review the basics. A share of common stock represents ownership in a business. Stockholders share in the fortunes of the business. If “your” company is doing well, your share price may go up. You may also receive dividends with a tax benefit – income you can reinvest or spend. The stock market should be used only for long-term investment funds. If you sell for a profit after one year and one day, you’ll pay taxes at a lower capital gains rate.
But corporations and the economy are subject to economic and political forces. Share prices can fall. The market itself has extended declines called bear markets. Think 200103, 200809. The bottom line with stocks is that reward is generally greater. But so is risk.
To lower risk, I recommend index investing. Sure, you can try picking individual stocks. Many investors think they can have better returns than the major stock averages. You might pick a winner. Yet often in our fastchanging world, “obvious” winners can quickly become losers. Worse, many investors hesitate to sell at a loss when a stock is plummeting. Their losses grow.
Index investing through mutual funds and Exchange Traded Funds gives you “ownership” of an entire market component – the S&P 500 or equiva lent. That can include all kinds of asset classes and international stocks, too. You spread risk and reward over many stocks.
“Importantly,” I told Sarah and Mark, “there’s little evidence that picking indi vidual stocks outperforms buying index funds. And you’ll sleep better.”
Bonds represent loans to a corporation or government agency. They’re more conservative investments because they pay a fixed rate of interest. While prices of existing bonds go up or down depending on market forces, prices tend to vary a lot less than do those of stocks. Moreover, if you own individual bonds at the end of the term (10, 20, 30 years, or whatever), the borrower repays your principal – the “par” or regular price of the bond. If you buy a new issue for $1,000, you get $1,000 back when the bond matures, or earlier if the issuer has a right to “call” or redeem the bond. Stock prices, on the other hand, always fluctuate.
Treasury bonds are the safest and pay the lowest interest rates. A corporate bond generally pays higher interest than a municipal bond. Corporations with lower credit ratings pay top money to borrow – but risk rises when you purchase “junk” bonds.
“I’ve heard about doubletaxfree bonds,” Mark said. Susan nodded. I smiled. As a California resident, if you buy state or municipal bonds, you pay no tax on the income you receive (usually twice a year). Depending on your earned income, doubletaxfree bonds may offer a higher net return than corporate bonds. Many of my clients, particularly those near or in retirement, devote a major portion of their assets to California municipal bonds to mini mize their taxable income and tax rate.
As with stocks, you don’t have to buy individual bonds. I buy individual bonds for my clients thanks to my knowledge of the market and my trad ing desk. Investors buying individual bonds have to do a lot of homework and hope to be able to secure those bonds at a fair price. However, you can buy bond mutual funds. They pay divi dends. They also spread risk by offering a variety of types of bonds. A tradeoff: The value of bond mutual fund shares varies each day, and when interest rates begin to rise, the principal value of each share declines.
Your key is diversification. A sound portfolio contains both stocks and bonds. “How much of each?” Susan asked. I chuckled. “That depends on your individual circumstances. One sizefitsall portfolios may not be right for everyone.” We started figuring out what would work for Susan and Mark.
Summing up: Stocks should offer a greater return than bonds to offset the risk associated with them. With both stocks and bonds spread over U.S. and international markets, and across asset classes, you can assemble a portfolio to meet your needs over time by providing ample reward while reducing risk.
Ira Fateman is a certified financial planner at SAS in San Francisco who conducts free personal finance workshops for Hebrew Free Loan (www.hflasf.org/financialfitness). Reach him at firstname.lastname@example.org.