Post of the Day
June 25, 1998

From our
Women & Investing Board

Subject: Diversification, risk, stocks and bonds
Author: JustAndy

Ok. This is a massive subject and not one easily tackled in a forum like this but I want to throw a few thoughts out for our particpants to reflect on.

As I hope everyone is aware, the "stock market" is by many measures at the top of, or way beyond, reasonable historic valuation. By this I mean certain averages of the S&P500 including dividend yield and the p/e ratio. Much speculation exists as to the cause of this. Answers include a long boom cycle in the economy and distortion caused by the baby boom generation's investment for education expenses for their children and their own retirement. If you want to get a better feel for the effect of the baby boomers on the economy relative to their retirement read this:

A typical cycle in the stock market looks like this. The booming "stock market" causes more folks to want to become investors. They put more money into stocks and this surge of demand causes prices of stocks to rise. Then economic conditions change (Asia?) and stock prices fall as investors lose confidence and more sellers than buyers are in the market. We have not had one of these drastic corrections in the last few years and the overpowering numbers of baby boom investors may be the reason.

This is not to say that a dramatic correction will or won't happen. As you read through the research dialogue above you will see that the predictions include net disinvestment in stocks as the boomers retire and start to turn investments into monthly spending money. That itself will likely cause a large and long decline in stock values.

"Don't let the magical stock market of the last few years fool you, there is a lot of risk there."  

Enter the use of bonds in investment portfolios. Bond holdings are used to diversify away from stocks and to counter the significant decline in principal that stock market valuation drops can cause to your portfolio as well as provide a steady and higher (than stock) dividend income stream. Cash holdings, such as money market funds, serve a similar purpose. Corporate bondholders have rights superior to stockholders. Bondholders get paid first and get claim on assets in dire situations. This is another portion of the reduced risk that bonds carry. The priority of bond and cash investments is reducing risk (preservation of capital), not maximizing return.

Don't let the magical stock market of the last few years fool you, there is a lot of risk there. Little or no investment in bonds and cash is risk taking behavior and is appropriate only for the very youngest investors who have time to replace their losses in the stock market if they occur. Standard, conservative investment advice is to have a portfolio containing a range of investment vehicles including stocks, bonds and cash in proportions appropriate to your age, source of income and other factors. In short, this is the old adage that your shouldn't put all of your eggs in one basket.

On this board, the idea of cashing in a bond holding when it's current value exceeds it's potential lifetime return has been suggested. That is a terrific idea. The question becomes where to invest the proceeds and this is where the investor needs to be careful. Because the original bond investment was designed to reduce risk, is it still important to your individual situation and needs to have that same amount of money invested in a risk reducing investment? It's an easily overlooked consideration in the shadow of the massive bull market of the last few years, but one you don't want to regret later.

If risk mitigation is important, then putting the proceeds in cash until interest rates rise a bit again allows you to retain the diversification and buy back into bonds at a cheaper price in the future.

If, on the other hand, other factors have caused you to not need that money in a diversified investment, the decision to invest in stocks with greater risk and greater potential return may be the right choice.

  "The balanced portfolio contain stocks, bonds and cash seeks to balance the risk and return needs through diversification."

A direct comparison of returns between stock and bond investments is unrealistic, since the main purpose of the two is different. It would be no different than comparing stocks and bonds solely on risk. Bonds would always win in that comparison, as will stocks in the return comparison.

The balanced portfolio contain stocks, bonds and cash seeks to balance the risk and return needs through diversification. My advice is to keep that in mind along with all of the other information one needs to be a successful investor.


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