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The Right Way to Balance Stock Risk

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Stocks may be the investment that will make you rich. But once you've saved up a decent nest egg, you'll need other investments to help you stay rich. With so many people scared of what the future of the financial markets will bring, picking the right fixed-income investments to counterbalance some of the risk of stocks is more important than ever.

The other side of the coin
In my column earlier this week, I talked about stocks that could help you build your life savings enough to have a great retirement. Although the lackluster stock market of recent years may have convinced you otherwise, the right stocks can grow at an extraordinary clip over long periods of time, turning even modest savings into small fortunes.

But as everyone learned during the bear market of 2008, stocks are risky. After watching the S&P 500 lose more than 50% in a year and a half, those who don't have the stomach for huge amounts of risk now value the security that fixed-income investments like bonds can bring. While stocks were falling 37% in 2008, Treasury bonds advanced sharply -- sharply enough that more conservative investors saw little or no damage to their portfolios during the market meltdown.

Bonds can be just as risky, though. With rates on Treasury bonds at extremely low levels, the odds of an interest rate rise that would decrease the prinicpal value of outstanding bonds are fairly high. In addition, default risk is present with most types of bonds. That makes it necessary to protect yourself by owning different types of fixed-income investments. Here's a brief overview of what a diversified bond investor should own.

1. Treasuries or bank CDs
Even though some believe Treasuries are in a bubble right now, it still makes sense to own some of them. The fact that Treasuries are backed by the full faith and credit of the U.S. government means that default risk is effectively nil. Similarly, FDIC-insured bank CDs have the same government backstop. Even if a bank fails, the government will step in and make you whole for deposits you have there, as long as they're within FDIC limits.

When buying Treasuries, you have two main choices. Buying bonds directly from the Treasury is possible through the TreasuryDirect website, which allows you to place bids and pay for bonds via electronic funds transfer from your bank account. Alternatively, you can find ETFs and mutual funds that specialize in Treasuries. Among them, iShares Barclays 20+ Year Treasury (NYSE: TLT  ) offers exposure to long-maturity Treasuries, which offer the highest yields, but also have the most interest rate risk. iShares Barclays TIPS Bond (NYSE: TIP  ) offers a unique type of Treasury bond whose value rises and falls with inflation and deflation.

In many cases, though, you'll find better rates through banks right now than with Treasuries. Treasuries are free of state income tax, though, so be sure to take that into account.

2. Corporate bonds
To earn higher yields than what ultra-safe Treasuries can provide, corporate bonds are a smart place to look. With bonds issued by companies, there's a higher risk of default, but the higher yield compensates you for that risk.

With the help of certain discount brokers, you can buy individual company bonds. They run the gamut from top AAA-rated issuers like ADP (Nasdaq: ADP  ) , which has enough cash on hand to repay all of its debt 50 times over, to junk-rated Ford Motor (NYSE: F  ) , whose $145 billion in debt dwarfs its $40 billion market cap.

Alternatively, the ETFs iShares iBoxx Investment Grade Corporate Bond (NYSE: LQD  ) and the SPDR Barclays High Yield (NYSE: JNK  ) own diversified sets of corporate bonds. The first focuses on higher-grade corporate debt, while the second owns junk bonds with high yields and greater default risk. Because junk bonds often track the stock market more than safer bonds, owning some high-yield debt can be especially effective in diversifying the bond side of your portfolio.

3. Municipal bonds
Finally, municipal bonds protect you against tax risk. While most bonds have their interest payments taxed at your high ordinary income rate, munis are free of federal tax. They pay lower yields, but on an after-tax basis, they often pay you more than traditional bonds.

Individual muni bonds can be tough to buy due to illiquidity and high minimum purchase amounts. But muni ETFs such as iShares S&P National Muni Bond (NYSE: MUB  ) aggregate many different munis in a single investment. Other ETFs are state-specific, owning bonds that are eligible for state income tax breaks as well.

Protect your portfolio
With promising stocks among your investments, you may be tempted to put all your money in them. But by incorporating a solid core of fixed-income investments, you won't have to worry so much about how to weather inevitable storms in the stock market when they come. That will make the path to retirement much smoother.

Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance.

Fool contributor Dan Caplinger keeps plenty of ballast in his portfolio. He doesn't own shares of the companies or ETFs mentioned in this article. Ford Motor is a Motley Fool Stock Advisor pick. Automatic Data Processing is a Motley Fool Income Investor selection. The Fool owns shares of iShares Barclays TIPS Bond. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy can balance on a tightrope and still chew gum and rub its tummy at the same time.


Read/Post Comments (3) | Recommend This Article (8)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 31, 2010, at 9:11 PM, goalie37 wrote:

    Someday I will buy bonds...but not now. As you point out, treasuries carry little risk of default, but the other risks are too great. If bond yields rise, which they will at some point, you will be faced with either owning a bond that pays almost no interest (probably less than inflation) or selling your bond for a sizeable loss. There is very, very little upside, except to hope the bubble goes further...and we all know from experience how well that strategy works.

    Under normal market conditions, the safety and fat yield of a bond is a great addition to a portfolio. Right now, not such a good idea.

  • Report this Comment On August 01, 2010, at 9:21 PM, TLassen wrote:

    Goalie37

    when you finally venture into buying bonds, you will quickly realize the advantage of holding bonds to maturity. Bond values will move with interest rates, but the reason you hold bonds in the first place is to have a clear picture of future cash flow paid back to you and to diversify away from high volatility stocks.

    Buy bonds, not bond funds.

    Hold to maturity (short to mid in a rising interest environment) then receive back your principal upon maturity.

    Try to ladder your bonds so there are always new ones maturing which would allow you to re-invest as the rates go higher

    Good luck..

  • Report this Comment On August 11, 2010, at 1:46 PM, whatsupfinance wrote:

    CXO has a good piece on whether or not to get into junk bonds:

    http://www.wallstmemo.com/news/2010/8/11/market-analysis-jun...

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Dan Caplinger
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Dan Caplinger has been a contract writer for the Motley Fool since 2006. As the Fool's Director of Investment Planning, Dan oversees much of the personal-finance and investment-planning content published daily on Fool.com. With a background as an estate-planning attorney and independent financial consultant, Dan's articles are based on more than 20 years of experience from all angles of the financial world.

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