When it comes to investing for beginners, you need to be very careful when comparing stock vs. bond funds because most beginners are unfamiliar with stock funds from bond funds. Now that I think about it, most of the people who invested money with me when I was a financial planner didn’t understand their bond funds, especially. In 2014 and beyond, this could prove costly.
Stock funds are a great way to invest for beginners who want to invest money in stocks. Most people grasp the concept and understand the risks involved. Bond funds are a different story. Most of the people who invest money in them tend to see these funds as very favorable for investors. After all, over a recent 30-year period they outperformed stock funds (stocks). Not only that, but they were rarely a bad year, while equity funds had a tough time.
Over the past year, a handful of my readers have objected to my warnings about bond funds vs. stock funds for 2014, 2015 and beyond. Let me explain and simplify investing for beginners, because this is a topic of importance to all investors. After all, you must own both types of funds to have a balanced portfolio; and this should be one of the objectives of every investor.
The question of stock vs. Bond funds are really a question of risk vs. potential returns. People understand that the former can be risky, but they accept it because they know that it can also be very rewarding. For example, equity funds had sports returns of about 30% in 2013. From their 2009 lows, they were up about 150%. Those kinds of returns are worth the risk. That’s investing for beginners 101. The higher the potential return … the higher the risk.
On the other hand, few average investors today understand risk vs. possible profitability problem when applied to bond funds for 2014 and beyond. In fact, many have stuck to these funds. After all, they have had a stable performance since the early 1980s and have paid attractive income (dividends) vs. safe investments like bank CDs. At the same time, the share price (value) has risen. The problem is that most investors do not understand the risk involved; And few understand WHY these funds have been such good investments.
What I emphasize in investing for beginners is that there are few things you can count on in the world of investing. For example, you can safely bet that there will always be uncertainty. And there is one more rule you can count on. When interest rates go down, bond prices (and bond fund values) go up; And when interest rates go up, they go down. When I was a financial planner, I explained this to all the clients I sold these funds to. It was rarely a problem, because interest rates peaked in 1981 and basically fell for more than 30 years.
Today’s average investor has never experienced an extreme economic environment of rising interest rates. Rates spiked to historically high levels in the late 1970s and early 1980s. Some investors had losses of nearly 50% on their bond funds in 1981. These investments are not safe, and the problem in 2014 And beyond that is the prospect of higher interest rates. With rates close to historic lows, this means you are taking the risk of earning a dividend of approximately 3% per year on longer-term bond funds. Also, the potential for rising stock prices (value) is unfortunate, as interest rates cannot go much lower.
Successful investing is always a challenge, and investing for beginners can be scary at times. I think 2014 and beyond could be a scary time for investors. Our government has lowered interest rates to EXTREMELY low levels to stimulate the economy. Now the powers that be are trying to resolve the situation. Interest rates could rise more than expected.
In stock funds vs. Bond funds debate the main theme I see is that risk vs. The potential returns are not favorable for bond funds because the potential returns are limited, as they have been for the past several years. If the economy stagnates and interest rates take off, both can be losers … both carry considerable risk in 2014 and beyond. Investment rule n. # 1 for Beginner Investing: When interest rates go up, bond prices and bond fund values go down.
Don’t despair, investing for beginners can be challenging. Keep this in mind: risk vs. Earning potential still makes investing money for higher returns the winner vs. saving it safely and earning peanuts.