Now Remember, Class: ‘D’ Stands for Diversification
Wall Street’s recent gyrations serve as a dramatic reminder that some investors may not want to rely on stocks alone.
Any investor who can’t stomach the idea of bouncing between being rich and poor with market moves needs a diversified portfolio that includes an investment or two from other key asset classes--bonds, cash and hard assets such as real estate or gold.
Diversification doesn’t guarantee that you’ll never lose money in a given year, but it tends to smooth out the ride.
Stocks, which reflect the performance of companies, have done better than other investments in the long run--especially, notably, in the last decade--but they won’t continue to do so in all periods. Therefore, if you’ve been so enamored with stocks lately that you forgot about these alternatives, it might be time for a refresher course.
By the way, basic diversification formulas tend to include big chunks of stocks and bonds, plus a little cash.
BONDS:
Bonds--government or corporate IOUs--provide a fixed stream of interest income, assuring you some return on your investment. Stocks can do the same through dividends, but bond yields tend to be well above most stocks’ dividend yields.
But bonds also have risks. If interest rates rise, your bond’s market value erodes, simply because older, lower-yielding bonds would naturally be worth less compared with higher-yielding newer bonds.
The longer you have to wait for your bond to mature, the more significant this risk becomes--although if you can hold until maturity, you can still expect to get the bond’s face value back.
With corporate and municipal bonds, however, there is also default risk--the chance that the bond-issuer will fail to pay you back. Defaults, however, are rare.
Where are the best opportunities in bonds today?
* Intermediate-term Treasury notes: Five-year Treasury notes are currently yielding around 6.6%--roughly a 3.5% return over the rate of inflation, says Christopher Orndorff, vice president of Payden & Rygel, a Los Angeles-based money management firm. They have virtually no default risk, and because they’re relatively short-term, their value is only modestly affected by market interest-rate swings.
Treasury notes can be purchased through brokers or directly from the Federal Reserve at public auctions. If you want more information, request a free booklet called “Buying Treasury Securities,” by writing to S. James, Consumer Information Center--6C, P. O. Box 100, Pueblo, CO 81002. Ask for Item No. 564C.
* Junk corporate bonds: For investors who want high yields, these bonds--issued by companies deemed by Wall Street to be higher-risk businesses--offer annualized yields of 8.5% to 10%, well above yields on super-safe Treasury securities.
In the early-1990s, junk bonds got a bad rap because a souring economy caused a large number of junk-bond issuers to default, said Blaine Rollins, the Denver-based portfolio manager of the Janus Balanced fund and the Janus Equity Income fund.
Most issuers, however, didn’t default.
The easiest way to own junk bonds is through mutual funds that specialize in them.
* Municipal bonds: The notes and bonds issued by states and municipalities pay interest free from federal income tax. Thus, depending on your tax bracket, muni yields can be quite attractive for investors who are looking for an assured return.
Again, the easiest way to own them is through mutual funds, although many investors prefer the greater sense of control they get by choosing specific muni securities.
HARD ASSETS:
The best known, and most popular, hard assets are gold and real estate. Over time, they’re believed to appreciate in line with the rate of inflation. As a result, they’re termed “inflation hedges” and lauded simply for their ability to save you from financial Armageddon. The theory is, when all else collapses, hard assets will still be worth their weight in hard assets.
The biggest shortcoming of gold is that it doesn’t generate any income--and often generates plenty of expenses--while you invest in it.
If you buy gold bullion, for example, you often have to pay to buy it, pay to store it, pay to test its authenticity and then pay to sell it again. Unless the underlying value of the gold rises fairly substantially--and gold’s historic performance has been notably lackluster--you lose money by simply paying all the fees.
With real estate, you pay trading and repair costs. Although it provides income if you rent it out or value if you live in it yourself, those expenses can add up.
If you don’t have the will or the wherewithal to buy your own home or apartment complex, you can still invest in the real estate market through a hybrid investment product called a Real estate investment trust.
Real estate investment trusts are structured very much like closed-end mutual funds. A number of investors put up a sum of money, which a REIT manager will use to buy commercial real estate--everything from apartment buildings to mini-malls--and rent it out. Investors are paid a return that’s derived from the rent. The REIT’s shares trade on a stock exchange.
CASH:
When professionals are talking about cash investments, they’re usually referring to one of a few things things: short-term Treasury bills, bank deposits or money market funds.
Cash investments have a simple appeal: They’re safe. Some are backed by the full faith and credit of the U.S. government, while other short-term investments are so varied and short that the risk is minimal. Also, these investments are liquid--i.e., easy to sell.
The shortcoming of cash investments is equally clear: They don’t pay a lot of interest.
But some analysts suggest that returns around 5% are still beating or keeping up with inflation, especially in a tax-deferred retirement account.
Bank deposits currently yield as much as 5.5% annually. Treasury bills and money funds are also in the 5%-6% range.
Anyone who needs money for a near-term goal--or who simply wants to step back from the stock market long enough to catch their breath--will find that cash provides a nice parking space, keeping your money safe and readily available until you want to use it.
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Remembering Other Options
Advocates for diversification argue that you should consider investments other than stocks. Over the past five years--a period in which average stock prices have almost doubled--gold has risen moderately and intermediate treasury notes have returned to the 5% to 6% range. But many stocks have done worse in that period, and the next five years could end with completely different results.
(please see newspaper for full chart information)
GOLD
Price per ounce
Friday: $385.70
FIVE-YEAR TREASURY NOTE
Friday: 6.63%
Source: TradeLine
