Are you a do-it-yourself investor who wants to build a great investment portfolio to achieve your financial goals? The good news is that, with all of the products available in today’s financial marketplace, it’s easier than ever to be a do-it-yourself investor. However, before you begin setting up your portfolio, there are three fundamental rules that you need to bear in mind in order to make sure you stay on the right track.
The first rule is to make sure your portfolio is properly diversified, to avoid putting all your eggs in one basket. For the average investor, that means that your portfolio should contain a combination of stock investments as well as bond investments. Having both stocks and bonds in your portfolio will help ensure that, in the event of turmoil in financial markets, some parts of your portfolio will do well even as others do poorly. In investment theory, it has been shown that stocks and bonds often tend to behave inversely to each other, with one doing well when the other does poorly. For example, during the recent financial crisis in 2008-09, stocks did relatively poorly but bonds did well. Including both asset classes in your portfolio helps avoid sharp swings in your portfolio’s value.
The second rule is to avoid chasing so-called hot investments. Often, you hear people in the media touting a certain investment that has been producing stellar returns, say 75% over the past 12 months. While it can be difficult to resist such eye-popping returns, it’s been shown that a strategy of chasing last year’s winners is a losing strategy over the long term. More often than not, last year’s winners end up providing mediocre or poor returns afterward, as the intense competition in financial markets makes it difficult to sustain such performance for more than a short time.
The final rule is not to try to time the market. When one asset class is doing poorly, many investors decide to sell their investments in that asset class and either purchase investments in another asset class or keep their holdings in cash. For example, during the recent financial crisis, after stocks had lost a lot of their value in 2008, many investors sold their stock investments in early 2009 and kept their holdings in cash. That decision turned out to be very costly, as stocks began to rise in March 2009 and ended up regaining much of the value they had lost. Those investors who had tried to time the market and sit on the sidelines missed out on that major rally and their portfolios suffered as a result. The lesson to be learned from that experience is that you should maintain your portfolio’s basic structure regardless of the direction of the market.
In summary, if you want a portfolio that will help you reach your financial goals, always remember: Stay diversified, don’t chase last year’s winners and don’t try to time the market. Happy investing!
Sunday, December 5, 2010
Protecting Your Investment Portfolio from Inflation
In order to combat the recent financial crisis, central banks around the world have increased the money supply by trillions of dollars. That means that, over the long term, there is the potential for a resurgence of inflation, or a rise in prices, which would significantly erode the purchasing power of your investment portfolio. Fortunately, however, there are some simple steps you can take to help protect your portfolio from the ravages of inflation.
One inflation protection strategy is to maintain an allocation in your portfolio to gold. As a hard asset, gold tends to increase in value during periods of inflation. There are several ways to gain exposure to gold. The most straightforward way is by actually purchasing gold bullion, which you can do through many banks. The problem with owning physical gold is that storage costs can be quite significant. Another way to gain exposure to gold is to buy shares in gold-producing companies, such as gold mining companies. The drawback of owning gold companies is that they don’t fully track the price of gold. That means that if, say, the price of gold rises by 20% in a year, the gold company’s stock price may only go up by 10%. As a result, you don’t get the full benefit of the rise in the price of gold. A better way to gain exposure to gold is through specialized investment products that are designed to mirror the price of gold. For example, you can purchase shares in an exchange-traded fund, or ETF, that tracks
the price of gold. This way, you can be sure that you will be able to fully benefit from a rise in the price of gold.
A second strategy to protect yourself from inflation is through commodities. Like gold, commodity prices generally rise during inflationary periods. While there are exchange-traded funds (ETFs) that track prices of commodities, such as oil, commodity prices can be extremely volatile, as we saw during the recent financial crisis, when the price of oil went from $140 a barrel down to $30 a barrel. If you had invested in an ETF tracking the price of oil during that period, you would have suffered extremely painful losses. A less risky way to gain exposure to commodities is by owning shares in companies, such as oil producers. There are many excellent international oil companies. While you won’t receive complete exposure to the price of oil, you’ll be more protected on the downside in case of a dramatic fall in oil prices.
Finally, a third way of achieving inflation protection is through real return bonds. In the United States, these are referred to as TIPS (Treasury Inflation Protected Securities). Real return bonds are securities that are specifically designed to increase in value with inflation. Unlike oil or commodities, real return bonds by definition rise in value with inflation. The way it works is that the bond payments are explicitly linked to a measure of inflation, usually the Consumer Price Index (CPI), which is a broad measure of price changes in the economy. You can purchase real return bonds through a broker, or, in the United States, you can purchase directly from the website of the U.S. Treasury Department.
By holding some of your portfolio in gold, commodities or real return bonds, you can feel secure in the knowledge that your portfolio is positioned to better maintain its purchasing power in a prolonged period of rising prices.
One inflation protection strategy is to maintain an allocation in your portfolio to gold. As a hard asset, gold tends to increase in value during periods of inflation. There are several ways to gain exposure to gold. The most straightforward way is by actually purchasing gold bullion, which you can do through many banks. The problem with owning physical gold is that storage costs can be quite significant. Another way to gain exposure to gold is to buy shares in gold-producing companies, such as gold mining companies. The drawback of owning gold companies is that they don’t fully track the price of gold. That means that if, say, the price of gold rises by 20% in a year, the gold company’s stock price may only go up by 10%. As a result, you don’t get the full benefit of the rise in the price of gold. A better way to gain exposure to gold is through specialized investment products that are designed to mirror the price of gold. For example, you can purchase shares in an exchange-traded fund, or ETF, that tracks
the price of gold. This way, you can be sure that you will be able to fully benefit from a rise in the price of gold.
A second strategy to protect yourself from inflation is through commodities. Like gold, commodity prices generally rise during inflationary periods. While there are exchange-traded funds (ETFs) that track prices of commodities, such as oil, commodity prices can be extremely volatile, as we saw during the recent financial crisis, when the price of oil went from $140 a barrel down to $30 a barrel. If you had invested in an ETF tracking the price of oil during that period, you would have suffered extremely painful losses. A less risky way to gain exposure to commodities is by owning shares in companies, such as oil producers. There are many excellent international oil companies. While you won’t receive complete exposure to the price of oil, you’ll be more protected on the downside in case of a dramatic fall in oil prices.
Finally, a third way of achieving inflation protection is through real return bonds. In the United States, these are referred to as TIPS (Treasury Inflation Protected Securities). Real return bonds are securities that are specifically designed to increase in value with inflation. Unlike oil or commodities, real return bonds by definition rise in value with inflation. The way it works is that the bond payments are explicitly linked to a measure of inflation, usually the Consumer Price Index (CPI), which is a broad measure of price changes in the economy. You can purchase real return bonds through a broker, or, in the United States, you can purchase directly from the website of the U.S. Treasury Department.
By holding some of your portfolio in gold, commodities or real return bonds, you can feel secure in the knowledge that your portfolio is positioned to better maintain its purchasing power in a prolonged period of rising prices.
Are Bonds Risk-Free Investments? Managing Default Risk in Your Bond Portfolio
After the stock market crash in 2008, many investors decided that they don’t want to take on risk by investing in the stock market. Instead, they have moved their investments to bonds, which they believe are risk-free. However, if we take a closer look at bonds, we will find that they contain their own significant sources of risk. Knowing how to manage this risk is the key to successful investing in bonds. In this article, we discuss default risk, which is the risk that the issuer of the bond will at some point not be able to pay the interest and/or principal due on the bond.
With regard to the bonds of major governments, such as the U.S. and the U.K, this risk is currently assumed to be minimal (although that could change over time if government finances worsen significantly). Corporate bonds, however, are another story. How do you assess the default risk of a corporate bond? The default risk of a corporate bond is generally a function of the company’s credit rating. Higher rated corporate bonds have a relatively small risk of default, as these are companies with a strong financial position. Lower rated companies, on the other hand, can default on a regular basis. The highest rating is “AAA”, followed by “AA”, “A” and “BBB”. Bonds rated below “BBB” are referred to as high yield bonds, and are issued by the lowest quality companies, which are prone to default. Of course, those companies pay the highest interest rates in order to compensate for the risk of default, hence the name high yield bonds.
It’s important to find out what kind of companies you are invested in so that you can assess whether you are comfortable with the level of risk in your portfolio. If you are invested in a bond fund, the material you receive from the fund on a quarterly basis should provide a breakdown of the percentage of the portfolio by credit rating. A modest allocation to high yield bonds should not drastically alter the risk of your portfolio. However, if your portfolio is dominated by high yield bonds, you may want to consider whether you are comfortable assuming so much risk. The percentage of lower quality companies that are defaulting is currently low, but it could rise if the economy takes a turn for the worse.
Being educated about the level of default risk in your bond portfolio will help you to be a smart and successful bond investor.
With regard to the bonds of major governments, such as the U.S. and the U.K, this risk is currently assumed to be minimal (although that could change over time if government finances worsen significantly). Corporate bonds, however, are another story. How do you assess the default risk of a corporate bond? The default risk of a corporate bond is generally a function of the company’s credit rating. Higher rated corporate bonds have a relatively small risk of default, as these are companies with a strong financial position. Lower rated companies, on the other hand, can default on a regular basis. The highest rating is “AAA”, followed by “AA”, “A” and “BBB”. Bonds rated below “BBB” are referred to as high yield bonds, and are issued by the lowest quality companies, which are prone to default. Of course, those companies pay the highest interest rates in order to compensate for the risk of default, hence the name high yield bonds.
It’s important to find out what kind of companies you are invested in so that you can assess whether you are comfortable with the level of risk in your portfolio. If you are invested in a bond fund, the material you receive from the fund on a quarterly basis should provide a breakdown of the percentage of the portfolio by credit rating. A modest allocation to high yield bonds should not drastically alter the risk of your portfolio. However, if your portfolio is dominated by high yield bonds, you may want to consider whether you are comfortable assuming so much risk. The percentage of lower quality companies that are defaulting is currently low, but it could rise if the economy takes a turn for the worse.
Being educated about the level of default risk in your bond portfolio will help you to be a smart and successful bond investor.
Are Bonds Risk-Free Investments? Managing Interest Rate Risk in Your Bond Portfolio
fter the stock market crash in 2008, many investors decided that they don’t want to take on risk by investing in the stock market. Instead, they have moved their investments to bonds, which they believe are risk-free. However, if we take a closer look at bonds, we will find that they contain their own significant sources of risk. Knowing how to manage this risk is the key to successful investing in bonds. In this article, we discuss interest rate risk, which is the risk of loss due to rising interest rates.
The reason interest rates pose a risk for bonds is that bond prices move inversely with interest rates. That means that if interest rates rise, bond prices fall. Interest rates are currently as low as they’ve been in a generation - it’s hard to imagine that they could go much lower. When interest rates eventually rise, bond investors could be in for an unpleasant surprise, as the value of their bond holdings will fall significantly.
How do you manage interest rate risk in your bond portfolio? The trick is to ensure that the average maturity of your bond holdings matches the time horizon in which you’ll need the money. The best way to do this is by purchasing a bond whose maturity date matches your time horizon. For example, if you need $10,000 in 10 years, you could purchase a 10-year bond with a face value, or a value at maturity, of $10,000. If you have an account with a broker, you can easily make this kind of purchase.
If you’re investing in a bond fund, the best thing is to tailor your fund holdings based on whether you would characterize your time horizon as short, medium or long. A short tome horizon would be less than five years, a medium time horizon would be five to 10 years, and more than 10 years would be a long time horizon. You can find fund families that have specific bond funds dedicated to each time horizon. For example, if your time horizon is five years, you should be looking for a fund that invests primarily in medium-term bonds. By matching the term of your bond holdings against your time horizon, you help insulate your portfolio from the risk of a loss of value due to rising interest rates, as the extra income that you receive from higher interest rates offsets the loss due to lower bond prices.
In summary, interest rate risk is controlled by matching the maturity of your holdings to your time horizon. Ideally, you should purchase a bond with a maturity date equivalent to your time horizon. In the context of bond funds, depending on whether your time horizon is short, medium or long, look for a fund that invests in bonds of that type. Being educated about managing interest rate risk in your bond portfolio will help you to be a smart and successful bond investor.
The reason interest rates pose a risk for bonds is that bond prices move inversely with interest rates. That means that if interest rates rise, bond prices fall. Interest rates are currently as low as they’ve been in a generation - it’s hard to imagine that they could go much lower. When interest rates eventually rise, bond investors could be in for an unpleasant surprise, as the value of their bond holdings will fall significantly.
How do you manage interest rate risk in your bond portfolio? The trick is to ensure that the average maturity of your bond holdings matches the time horizon in which you’ll need the money. The best way to do this is by purchasing a bond whose maturity date matches your time horizon. For example, if you need $10,000 in 10 years, you could purchase a 10-year bond with a face value, or a value at maturity, of $10,000. If you have an account with a broker, you can easily make this kind of purchase.
If you’re investing in a bond fund, the best thing is to tailor your fund holdings based on whether you would characterize your time horizon as short, medium or long. A short tome horizon would be less than five years, a medium time horizon would be five to 10 years, and more than 10 years would be a long time horizon. You can find fund families that have specific bond funds dedicated to each time horizon. For example, if your time horizon is five years, you should be looking for a fund that invests primarily in medium-term bonds. By matching the term of your bond holdings against your time horizon, you help insulate your portfolio from the risk of a loss of value due to rising interest rates, as the extra income that you receive from higher interest rates offsets the loss due to lower bond prices.
In summary, interest rate risk is controlled by matching the maturity of your holdings to your time horizon. Ideally, you should purchase a bond with a maturity date equivalent to your time horizon. In the context of bond funds, depending on whether your time horizon is short, medium or long, look for a fund that invests in bonds of that type. Being educated about managing interest rate risk in your bond portfolio will help you to be a smart and successful bond investor.
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