Know what you’re buying: Stocks and Bonds - Ch 3 Boglehead Series at Catch a Gideon

November 1st, 2006 by digerati

This is the third chapter of the Boglehead series here at Successful Personal Finance.com. The Boglehead Guide to Investing is a great book on investing that covers the basics in enough detail to get you started.

Know What You’re Buying: Part One - Stock and Bonds

Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years. – Warren Buffet

Mutual fund investing is the best route for most investors in most situations. (Notice we did not say all investors or all the time!)

Stocks

Stocks represent a share of ownership in a corporation. Proceeds of issuing stock is used to fund the business.

Once initial issue is completed, stock shares can then be exchanged (bought and sold) on markets. The price is determined by what the buyer is willing to pay and what the seller is willing to accept. The prices naturally fluctuate continuously when the markets are open. If you sell the stock at a higher price than when you bought it you will make money. If you must sell at a lower price you will lose money.

If you will invest in stocks it is usually good advice to diversify, that is not place your entire investment in a single stock as your investment then rest upon the fortunes of a single company.

Bonds

When you purchase a bond you are actually lending a particular amount of money to the bond issuer.
After a specified period of time you reach the maturity date when you receive back the face value of the bond, plus an agreed upon return on your investment(ROI). Bonds can be for a short term (a year or less) or long term (10 or 30 years). Typically the ROI (the interest) is paid out semi-annually. Bonds are issued by governments, municipalities, corporations, and government agencies.

Treasury Bonds

These are considered very safe investments because they are backed by the credit of the United States government. They include several types:

T-bills (13 or 26 week), T-Notes (2,3,5 and 10 year), and T-Bonds (over 10 year). Collectively called Treasuries.
TIPS (Treasury Inflation Protected Securities) - these are discussed in chapter 5
US Savings Bonds - types I and EE, both must be held for at least a year. I bonds are in chapter 5. EE bonds are guaranteed to double in value in 20 years (minimum return of 3.526%). The actual rates are determined with a secret formula. New rates are announced each May and November. Savings bonds can be tax deferred for up to 30 years, and are not taxed at the state and local level.

How to Buy Treasury Issues

T-Bills, Notes, and Bonds, and TIPS can be purchased at your bank, your broker (they will probably charge you a fee) at auction (call any Federal Reserve bank) or at www.TreasuryDirect.gov. Savings bonds may be purchased online as well or at most banks.

Corporate Bonds

Issued by corporations (hmm…). Proceeds used for expansion. The yield of a bond is determined by:

credit of the issuer
current yield of bonds with comparable safety ratings and maturities. Ratings are done by companies such as Standard and Poors. Investment grade bonds range from AAA down to BBB-. Lower rated bonds (aka junk bonds) are considered speculative since they are very high risk.
demand for the bonds
call feature of the bonds

Municipal Bonds

Issued by state and local governments. Usually tax free at the federal level as well as state and local. The tax advantages can be substantial for those in higher tax brackets.

Maturity and Duration

Duration is stated in years with a decimal. There is an inverse relationship between interest rates and bond prices. When interest rates fall, bond prices will rise. If a duration of 4.3 years, then if interest rates rise 1% the bond holder can expect a 4.3% decrease in their investment. You will only see a gain or loss on the investment if you sell the bond in the secondary market. If you hold the bond until maturity you will receive the full value.

Selecting a Bond Fund

Find a bond fund that matches your investment time horizon. If you need the money in 3 years don’t choose a fund with a 5 year duration.
Don’t time interest rate hikes. Plan to hold for the fund’s duration or longer.
Match your fund to your risk tolerance.

Bogleheads say to add bonds to your portfolio to balance the stocks. Stock and bond prices are not necessarily correlated, so when stock prices are down bonds prices may be up.

Bogleheads also say to base the percent of bonds in your portfolio on your age. If you are 20 you should have 20% of your portfolio be in bonds. From there, increase bonds to be more conservative and decrease bonds to be more aggressive in investing.

Have you bought the Bogleheads Guide to Investing yet? If you like my summaries you should get the book for added details and explanations.