Keeping things simple usually makes sense. Sometimes, though, oversimplifying something causes you to make huge mistakes that can cost you more than you'd ever imagine possible.
With investing, one of the most deceptively simple concepts you run into is risk. From the moment you start to invest, you're taught that things like bonds, bank CDs, and money-market funds are "safe" investments. Other types of assets, such as stocks, options, and commodities, are "risky" investments. Armed with that simple knowledge, beginning investors weigh their risk tolerance and divide their money between these investments with the thought that they're controlling the risk in their portfolio.
Are bonds really safe?
You can see that happening now. Investors are piling into bonds and bond mutual funds of all sorts, seemingly heedless of exactly which type of bonds they're buying. According to the Investment Company Institute, from January to September, investors added $213 billion in net new cash to taxable bond funds, with municipal bond funds also seeing inflows as well.
Unfortunately, there's a lot more to picking a smart allocation between stocks and bonds than just a beginner's concept of risk. In particular, if you conclude that bonds are always a safe place to put your money, you'll be totally unprepared for the consequences if the risks involved with bond investing become reality.
Lots of different risks
In fact, in some ways, the risks associated with bonds are more complicated than stock risk. With a stock, the primary risk is business failure; if a company loses enough money, it will have to go out of business or declare bankruptcy. Although some post-bankruptcy stocks like Sears Holdings
In contrast, bondholders sometimes recover part or all of their investment even if a company goes bankrupt. But depending on what sort of bonds you buy, you might face several different and largely unrelated types of risk. Here are some of them:
Default risk. This is the risk that most people associate with bonds: the possibility that a bond issuer won't repay the money it has borrowed from bondholders. Treasury bonds are seen as having no default risk because they're backed by the full faith and credit of the federal government. Highly rated corporate issuers like Microsoft
(NASDAQ:MSFT)and Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B)aren't quite as safe, but they're seen as safe enough that the chance of default is minuscule. High-yield junk bonds from issuers like AMD (NYSE:AMD)and Ford Motor (NYSE:F), on the other hand, involve a higher chance of the issuer not being able to pay off their bonds. Even the threat of default can cause ratings agencies to cut ratings, which can in turn hurt bond prices.
- Interest rate risk. Rates on fixed-income securities are relatively low right now. If prevailing interest rates rise, then the prices of existing bonds will typically fall -- regardless of whether those bonds are "risk-free" Treasuries or junk-rated corporate bonds. Moreover, bonds that have a long time left before they mature will suffer more from higher rates than those maturing sooner.
- Inflation risk. Most bonds only promise fixed interest payments and a fixed payoff at maturity. Although you'll know in advance how much money you'll receive, you don't know how much inflation will reduce the purchasing power of those payments. That's one reason why inflation-indexed bonds like TIPS have become popular, since they include adjustments for changes in the consumer price index.
- Reinvestment risk. Unlike stocks, bonds mature. That means that at some point, you'll get your money back, and you'll have to figure out what to do with it. If interest rates have fallen in the meantime, then you'll be stuck having to buy bonds that won't give you as much income.
In addition, buying and selling bonds isn't as easy as trading stocks. Although many discount brokers offer bond trading, you won't always find a buyer waiting to buy when you're ready to sell -- especially if you're trading small quantities of bonds.
Buy bonds ... carefully
Bonds certainly deserve a place in the portfolios of most investors. But don't deceive yourself into thinking that bonds don't involve risk. It's essential for you to understand what can go wrong with buying bonds so that if conditions warrant, you can take steps to protect yourself from bond risk.
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Fool contributor Dan Caplinger is a closet bond-junkie. Both he and the Motley Fool own shares of Berkshire Hathaway, which is a Motley Fool Stock Advisor recommendation. Berkshire Hathaway, Microsoft, and Sears Holdings are Motley Fool Inside Value picks. Motley Fool Options has recommended a diagonal call on Microsoft. The Fool's disclosure policy keeps you safe and warm all winter long.