In my last post I said there are two general ways to make money from investing: owning or loaning. We’ve already covered the “ownership” asset classes so today we’ll talk about “loanership” investments.
Bonds come in many forms but all of them are nothing more than glorified IOU’s.
When a company wants to raise capital without issuing stock it can borrow money. Or when government spends more than it collects through taxes it has to borrow to keep operating. This often requires huge sums of money— more than banks can provide—so they go to the public market to find investors willing to lend a portion of what is needed in exchange for a bond.
When you buy a bond you are loaning money for a specific length of time—the term—at a specific rate of interest so you know exactly what you are getting before you buy them. The interest rate for a bond is frequently referred to as the coupon rate. This terminology is a holdover from the days when paper certificates were issued. Each certificate had a tear-off portion, or coupon, that the bearer redeemed for cash when an interest payment came due. Now everything is electronic.
If you or I apply for a loan, the first thing any lender does is check our credit score. Bond issuers have credit ratings, too. AAA ratings indicate the highest quality while companies on shaky financial ground might get a BB (or lower) rating. As with growth stocks, the higher the risk, the higher the return. They don’t call them junk bonds for nothing!
When the big players need to borrow cash for short periods, they are likely to turn to the money market. Like bonds, money market instruments are basically IOUs issued by the government, banks and large corporations but usually for terms of less than one year—some are as short as one day. You make money from these fixed income investments in the form of interest payments. Offerings in the money market, such as CDs, are considered extremely safe, so that means significantly lower returns. Currently, CDs are paying around a paltry 1%.
So how do you keep everything safe?
You don’t. There is no such thing as a risk free investment but you will also lose money if you don’t invest. Let’s say you decided to put your hard earned cash in a mayo jar and bury it in the back yard. You would still lose some because the value would erode due to inflation. The old advise about not putting all your eggs in one basket a.k.a. asset allocation is still sound. The tricky part is deciding how much to put in each basket. This decision is based on:
- Your time frame
- Your personal goals. What are you saving for?
- Your temperament
- Your tolerance for risk
And now some unsolicited words of advice:
- Never invest in anything you don’t understand. If it sounds too good to be true. . . .
- Learn to speak the language of finance and then find a good financial advisor for guidance and collaboration.
- Choose your advisors with as much care as you choose your physicians—your financial health depends on it.
Next: My last words on the subject of finance—I promise!