Debunking Financial Myths Part 3 – Bonds Protect Against Market Losses
Not a myth. Here’s why: while bonds are “investment securities,” they are not the same as stocks. Usually, when people refer to the “market,” they are referring to the “stock market.” There is actually a separate “bond market,” where bonds are bought and sold by investors after they are issued by the borrowing company. When an investor buys a bond, they are lending money to a company. When an investor buys a stock, they are becoming part owner of a company. Investors can lend to or own parts of hundreds of companies by buying a mutual fund.
Bonds are different. Although it may sound like a circular explanation, bonds can help protect against stock market losses because, to the extent they are added to an otherwise stock-only portfolio, they can reduce how much the overall portfolio would be affected by stock losses. In other words, stocks and bonds don’t move in “lock-step.” This is because what affects the value of stocks may or may not affect the value of bonds in a portfolio. Depending on the objectives, preferences, and risk tolerance of a particular investor, adding bonds to a stock portfolio may be an appropriate step toward diversification.
Bonds bring diversification that can help reduce risk. However, that does not mean they bring no risk. Bonds come with their own set of risks that are different than stocks, hence the resulting diversification. Bond risks include interest rate risk (when prevailing interest rates go up, bonds typically go down in value) and default risk (a bond is only as good as the issuing company, municipality, or government’s ability to pay the principal bond value back at maturity; if the bond issuer goes out of business, typically, you don’t get your money back).
Greater diversification can be achieved with a mix of different types of bonds. Many investors and mutual funds will take the additional step of buying 1. short-, intermediate-, and long-term bonds; 2. high quality and lower quality bonds; 3. corporate, municipal, and governmental bonds; and 4. domestic and foreign bonds. Depending on market conditions, interest rates, and an individual investor’s situation, a mix of some or all of these different bond types might be appropriate and helpful.
I’m just getting warmed up! Email me at firstname.lastname@example.org if you have any myths you’d like debunked. We’ll continue this series next week.