Should you think like a stock or a bond?

06/02/2020

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Should you think like a stock or a bond?

There’s a lot of talk about stocks and bonds these days, and it all focuses on your investments. But there is another type of financial resource or capital that we are not talking about. And that’s you! Have you ever asked the question “am I a stock or bond”? This may sound like an odd question but stick with me. Your answer can help you shape the investment approach that makes the most sense for you.

It’s all about better managing risk and better aligning your human capital with your financial capital.

The Personalities of Stocks and Bonds

We tend to think of both stocks and bonds in terms of risk and reward. Stocks have a much greater potential for reward, but they also tend to be more volatile than bonds. As we’ve seen recently, the stock market, as well as individual stocks, can gain or lose a significant amount in a short period of time.

Bonds, on the other hand, tend to be much more slow and steady. Depending upon interest rates and other factors, the value of bonds can change, but they don’t have the same volatility as stocks in most cases.

Historical returns tell the story. According to Morningstar, a global investment research and investment management firm headquartered in Chicago, since 1926 large stocks have returned an average of 10% per year, while long-term government bonds have returned 5-6%.

Those numbers hide the differences in volatility, though. The S&P 500, including dividends, has jumped as much as 52.56% in a year (1954) and dropped by 43.84% (1931). In more recent times, since 2000 the best year for the S&P 500 was 2013 (up by 32.13%); the worst was 2008 (dropped by 36.55%).

In contrast, U.S. treasury bonds, which have maturities of 10-30 years, often post gains or losses of single-digit percentages. The last time long-term government bonds gained or lost more than 10% in a year was 2014 (up 10.75%). Short-term government bonds

(three-month Treasury bills) haven’t seen double-digit volatility since 1982.

How Your Job and Your Investments Should Work Together

So are you a stock or a bond? Here’s what I mean.

Let’s say you’re a sales rep for your company, and much of your income is commissions. That means your income can vary widely: this month you’re blasting through your goals and getting a bonus; next month sales are a lot slower. Like a stock, in the long run you’ll do well, but week-to-week or month-to-month your income is volatile.

You’re a stock.

Your friend is a teacher. They get a cost of living raise every year, and periodically get a salary bump based on their years of service. No big dips or jumps.

They’re a bond.

If you’re a stock, with an income that can be volatile or risky, it makes sense to balance your income risk with a portfolio that’s less risky or volatile. You wouldn’t want to be in a position where both your income and your investments drop at the same time. On the other hand, if your income is fairly steady and assured, that’s the safety net that allows you to take a bit more risk with your portfolio.

This shouldn’t be the primary driver of your financial plan. Either on your own or with the help of a financial planner, your investments should be tailored to your goals, age, and risk tolerance. But once you have your basic portfolio, such as 60% equities, 35% bonds and 5% cash, those percentages can be tweaked depending upon your employment/income situation.

Stocks, Bonds and Emergency Savings

The same thinking should help you determine how much cash you have in an emergency fund. The rule of thumb is that you should have 3-6 months of your living expenses in cash for emergencies.

I have a problem with that idea for two reasons:

  • Rules of thumb are general and don’t apply to everyone
  • An emergency fund doesn’t have to be cash; access to credit (such as a HELOC) are functionally equivalent

If your income fluctuates or your job is volatile, you probably should have more of an emergency safety net. On the other hand, if your income is steady and your job is assured, you can probably get by with a smaller emergency fund.

And, as I mentioned above, setting up a HELOC or other line of credit now, before you need it, can also serve as a financial emergency net.

Reducing Risk

Whether you’re a stock or a bond, there’s a way to tilt the trade-off between risk and reward in your favor: build your own safety net.

When Bill Gates dropped out of Harvard to start a small company he and co-founder Paul Allen initially named Micro-Soft, his parents and others urged him to reconsider this risky move. But Gates, who later became the world’s richest man (and youngest self-made billionaire), had a backup plan: the one-time poker player had hedged his bet with a commitment from Harvard that he could return to campus if his fledgling software company didn’t work out.

In an interesting twist, he did return to Harvard: 30 years later to receive an honorary degree in law, which was his original field of study. 

You might not be enrolled in Harvard. (I certainly wasn’t!) But you may have other options for reducing your risk, whether you’re a stock or a bond: turning a hobby into a second income stream, negotiating an employment contract with certain guarantees, and the list goes on.

But whatever you do, recognize how to balance income risk and volatility with investment risk. You’ll sleep better at night.

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