WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK. FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON
Some Wall Street professionals
devote their time to buying debt at one market interest rate and selling it at
another. They trade based on their expectation of the
direction of interest rates in the short term. Bond prices and interest rates move in opposite directions. As we learned in the last blog, if market interest rates rise above a bond's rate, the market price of the bond will drop. Conversely, if market interest rates drop below a bond's rate, the market price of the bond will rise. Bond traders look for a profit in the interest rate fluctuations rates and the resulting movement of bond prices. Although the security being traded is a bond, the profit is based on interest rates. Another way to trade on interest rates is the purchase and sale of bond futures contracts. This is too complicated for me to explain so I provided a link, but, obviously, it is a market
strategy for professional traders, not individual investors.
So, what is an individual investor to do?
One of the basic rules of investing is asset allocation. This means dividing your investment portfolio into three categories, equities, debt and cash. Conventional wisdom holds that a person should have the equivalent of three to six months of monthly wages put aside in savings for the inevitable "rainy day." This war chest should be accumulated before a person considers any equity or debt investing. As to the division between equities and debt, the old rule of thumb is that you deduct your age from 100. Your age is the percentage of your portfolio to be invested in debt and the difference is put into equities. If you are young, the majority of your investments will be in stocks. As you age, your portfolio allocation shifts to keep the percentages of debt and equity in line with the rule. Generally, stocks, like bond prices, and interest rates move in opposite directions in the market. Although stocks are viewed as riskier than debt instruments, they have generated annual returns of somewhere between nine and ten percent over several decades. If interest rates are high, in double digits, investors move into the debt market to garner these returns without the perceived risk of equities. When interest rates are at levels below the expected returns on stocks, investors gravitate back to the stock market.
This general rule provides an answer to the question of what to do; however, it provides no answer to the question of why to do it. Why an individual is making an investment is the most important issue to resolve before actually investing. Since trading debt is really an interest rate game, it is probably best left to the professionals, as I said earlier. The individual investor should view debt more as the place to put a portion of his or her money to keep it "safe" rather than as an investment with an interest return. The fact that the money is "safe" from equity market risk is more important than the yield made on the debt. Many people liken the stock market to a casino. There are very few big long term winners in either. As Kenny Rogers sang in his hit song, The Gambler, "You never count your money when you're sitting at the table." When the stock market is on a roll and your equities are soaring, it is counter intuitive to sell some of that stock. However, if you want to keep those gains, take some of the chips off the table. You should put some of those profits in a place where, as my Father used to say, "Wall Street can't get it."
Savings accounts and certificates of deposit in federally insured institutions and short term US Treasuries (maturities of less than a year) are dull, pedestrian investments, but they provide the individual investor with places to put their money with little risk of principal loss. If an individual investor wants to buy US Treasuries without incurring a brokerage fee or commission, he or she can buy from the US Treasury at Treasury Direct.
Comments are always welcome.
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