Balancing Fixed Income with Other Investments

Fixed income investments do provide a reliable rate of return over time, set by the interest rate at the time of purchase of the investment. These rates do tend to be close to the rate of inflation at the time, with a premium being paid according to the perceived risk of default of the investment.

One can get quite high rates of return with some of these investments, from countries or companies that are struggling a lot, but if one seeks to get a better return from taking on more risk, there are more appropriate ways to do this besides buying things like junk bonds and such.

Balancing Fixed Income with Other InvestmentsOne can, for instance, invest instead in a solid stock, where the risks can be much better managed with only a modest amount of skill, by paying attention to markets for instance and only being in the investment when conditions are more favorable and out of it when things are not so favorable.

With high risk fixed income investments, the risk stems from more fundamental risks and when the returns from these investments go up a lot this in itself signifies some real trouble. While we may be able to trade these bonds successfully, they are difficult to trade, and when we invest, we do look to stay in them longer term and therefore do not have a process in place to run when we need to.

Should these risks escalate, we’ve only been paid based upon the risks at the time of investment, so this can certainly have our return and the present risk much misaligned, as this is only aligned at the time of the purchase and these risks can certainly change.

If you are fortunate enough to get in when the risks have been high and see them go down, like people who bought Greek bonds when they were paying out a lot, this can benefit you, but this is a very risky strategy that is well beyond what ultra conservative investors should be even contemplating, and is more for very risk loving traders who can afford to lose all their capital on a trade.

The opposite is the case for most fixed income investors, as this usually represents their life savings and what they expect to live on for the rest of their lives. This is no situation where you want to be taking on any more risk than you have to, so the higher yielding fixed income investments aren’t really something that these investors should be looking at, even when combined in a diversified bond portfolio.

The problem with diversifying is that if a component doesn’t make sense individually, and especially if it makes no sense, then watering it down by diversification doesn’t either. Funds don’t generally actively trade these riskier investments in the way that is required, for instance calculating the probability of conditions changing favorably and only being in then, with one eye on the door, they usually just buy and hold and hope.

This is not the best strategy with anything and especially not with riskier investments, which require even more attention to manage the risks involved.

Looking to Balance With Other Types of Investments

While some people exclusively invest in the safest fixed income investments, U.S. treasuries for example, this does not grow their money in a real way, as all you do here is keep up with the inflation rate at the time of purchase. If this rate goes up, you fall behind.

On average, you need to save up everything you will need when you look to spend your savings, which can be a significant amount. If we have achieved this, then we can live quite comfortably on our savings with fixed income investments, which again will preserve their original value on average.

For those who fall short of this goal, and many do, we may want to seek to grow our capital throughout, even in retirement. However, our time horizon is shorter at this point, and therefore it may not be wise to use a complete buy and hold approach, like we usually do as we’re saving up for this in the early to mid periods of our careers, but there are some adjustments that can be made to compensate for this.

A properly managed portfolio should not even require one to commit to fixed income completely, as the commitment would depend on the circumstances of the market, Ideally, if one wanted to take a balanced approach to stocks and bonds, one would be in the stock market when the going is good and be in bonds when it isn’t.

We do get some pretty significant bear markets as far as longer term trends go, but even in these longer bear markets which can last 10 or 20 years, there still are some bull and bear variations of shorter duration.

Even in the most persistent bull markets, there are shorter term bear markets that emerge, and nothing goes straight up or down, in any time frame.

The more decisions we have to make, the greater the chance that we will make mistakes, but the biggest mistake is not to have a plan at all, to take a certain percentage of our portfolio and put it in bonds and the rest in stocks. This is a complete lack of risk management in fact, at least in a dynamic sense.

When we invest in anything, we do so with a certain expectation, a certain upside and a certain downside, and we invest when things are favorable according to our best judgements.

As time goes on, things change, and if we are not able or willing to adapt to these changes in an appropriate manner, we subject ourselves to whatever risk emerges, and whatever conditions end up prevailing.

This is a lot like driving a car in what are now good road conditions, but if the road conditions deteriorate, we’re going to need to be able to adapt our driving to suit these new conditions. In a real sense, classic investing is like driving a car and not paying attention to the road at all.

It’s Not How Much You Need To Allocate to Each Type of Investment

Depending on our circumstances, we may want to allocate a certain portion of our savings to fixed income investments, for instance if we have enough that this will assure us of living comfortably and we don’t want to take on any more risk.

We may be able to do that and still have an amount that we can take more risks with, and in this case, this would represent a hybrid approach where the core portion of our portfolio will be left alone and the secondary part we can play around with more, like for instance investing in the stock market or other higher risk investments.

Often times though, we’re not going to have enough or be likely taken care of enough even if we put all our money in fixed income, which will require a more aggressive approach than this, with our needing to be willing to take on more risk to seek out returns which are higher than inflation.

The common approach to do this is to look to allocate a certain portion of our portfolio to fixed income and the rest to things like stocks, almost always stocks in fact. Stocks are like bonds in that they don’t really require much attention if we don’t want to devote much, unlike things like futures trading which does require a lot of attention and skill.

This static approach to allocation is inferior though as it does not adapt at all to changing market conditions, and in particular, changing risk. We don’t even pay attention to the state of the market even at the time of investment, where we are content to just cast our money into the wind and hope that it blows in the right direction, and continues to, rather than looking to gauge the wind now and monitor it for changes.

We could say that the wind has blown more north, bullishly, than south, bearishly, when we look at very long historical time frames, but it still does change direction quite a bit and this is not in any real sense managing change or potential change.

Coming up with a plan to put a certain percentage in fixed income and a certain percentage in stocks to look to fit our individual needs and circumstances may seem like a good idea, but is actually an inferior one that is more reckless than anything.

Coming Up With the Right Mix

The right mix of investments for us is going to depend on our needs, but it also will depend on what opportunities are present at a given point in time. If, for instance, we need to grow our portfolios more, and are considering moving a good portion of our capital into stocks, and we’re in a bear market, this cannot be a good idea unless the goal is to purposely deteriorate our situation.

We at least need to have a reasonable expectation of success when we do this, and when things are going in the right direction, this can be a marvelous idea, but if they are not, it can be a terrible one.

We could even say that there is an ideal approach here and it would be to not even consider our needs, and instead we could just assume that the goal is to grow our portfolios in a way that incorporates enough safety. Risk is always going to be a big deal with investments, regardless of our needs and approaches, and this has to be a primary goal.

Ignoring the dynamic nature of risk will simply not achieve this very well, and while we can say that it is preferable to hold a balance of stocks and bonds instead of having all of our money in stocks to manage risk, the amounts we hold in each should depend on the outlook and performance of the investments.

Even folks who have enough money to be comfortable even if they kept it under their mattresses should look to take advantage of changing circumstances, although in this case they probably should keep enough in the safest of investments to assure their continuing comfort, while looking to make better money from the rest of their capital.

Doing this properly requires us to first assess the state of the markets involved, the bond and stock markets for instance, and then look to act on any changes that are significant enough to require attention and action.

So, the answer to the question of how much we should put in fixed income which basically preserve our capital and how much to take risks with in stocks really depends not so much on our needs as what state these markets are in and what the outlook for them over a certain period is.

While most of us do require that we grow our capital and cannot merely rely on preserving it with fixed income, we do need to pick our spots, and seek to pick them well. The better we do this, the better off we will be.

Eric Baker

Editor, MarketReview.com

Eric has a deep understanding of what moves prices and how we can predict them to take advantage. He also understands why so many traders fail and how they may help themselves.

Contact Eric: [email protected]

Areas of interest: News & updates from the Commodity Futures Trading Commission, Banking, Futures, Derivatives & more.