In the previous three articles in this series, we’ve talked about how to save money, the short-term security you should save for, and the first important step in investing: savings. Now, we’ll continue with the following steps in the wealth-building strategy: diversification. In addition to the cash and the stocks you hold, the main things to diversify with are bonds and real estate. We’ll cover bonds first, and in the following article, we’ll cover real estate.
With your ETF-based stock market strategy, you’re already relatively well diversified and, theoretically, liquid, as you can sell stocks anytime. However, since the market is volatile, some days (or years) might be better than others to sell your stocks. So, if you plan to have liquidity at a certain point, bonds are an excellent way to transition.
First of all, what are bonds? Companies or governments issue bonds, and you, as a bondholder, give the company or the government essentially a fixed-rate loan; at maturity, the bond issuer pays the principal and the interest. They have different durations and yields based on when they were issued. Bonds can also be traded on the secondary market at any point, so the bondholder is not locked in holding them to maturity.
So, unlike the stock market, the nominal return percentage on the bond at maturity is guaranteed, of course, as long as the entity issuing the bond doesn’t go out of business. For this reason, in this article, we’re only considering government bonds, particularly the US ones, since the US government can’t go out of business (or we have much bigger problems than our savings).
On average, bonds will always have a lower yield over a long period than the stock market for a simple reason: they are essentially zero-risk. If you have a zero-risk guaranteed investment and a somewhat risky investment, the riskier investment needs a higher yield for you to consider.
So, if you plan to have liquidity in 10 years, you can start selling stocks and buying bonds periodically (preferably with a maturity date close to when you plan to liquidate). Treasury bonds can have various yields based on the interest rate at the time they were issued, but, just like with stocks if you buy them regularly, you’ll get a good deal on average.
The only thing working against you with bonds is inflation; if you hold a bond giving 3% while inflation is 2%, you’re doing 1% net profit; however, if inflation grows to 4%, that same bond nets you a 1% loss; also, while the inflation is 4%, the government will be selling new bonds with 5% yield, so selling the 3% bond on the market will need to be at a discount. Also, some markets, including the US one, offer TIPS (Treasury Inflation-Protected Securities), which, as the name suggests, has variable yield based on inflation.
So you can balance stock investments with bonds, with a balance favoring stocks while you are young and tilting toward bonds as you get closer to retirement; this is called “age-based asset allocation.”
In conclusion, bonds are similar to stock investments and are an easy way to diversify, especially to plan for liquidity. Next time, we’ll cover the diversification into real estate that deserves its own article.