The Closest Thing To A Free Financial Lunch

When it comes to investing there’s an inevitable rule that tends to drive people crazy. Everybody wants the best possible growth for their investment dollar, and we all want that growth with minimal risk.

Risk-Growth Relationship

The inevitable rule is that risk and growth share a rather nasty love–hate relationship. In order to achieve better than average growth you must take on greater risk. This can sometimes provide spectacular results, however it can also lead to devastating losses. The flip side is the desire to invest in the safest way possible and still get fabulous returns.

So is it possible to get close to the ideal situation where you have decent growth without taking on excessive risk? It’s very rare indeed, but it is possible.

Safe Investments?

When we think about safe investments with minimal risk, the logical choice is bonds. The price you pay for all that safety is the fact that bond returns have historically lagged behind the stock market, and often barely keep up with inflation.

In fact, with the record low interest rates we’ve seen over the last decade, bonds have been considered real dogs when it comes to investing. I mean, who could justify tying up their money for a measly one percent return?

Now I will openly state that I am no expert and have only a very basic idea of what drives bonds rate up. But I see the economy changing and we’re in a strange situation which could lead to bonds being the closest thing to a free lunch. What do I mean by that?

With record rates of inflation and strong action to raise lending rates, bonds are seeing a revival. Additionally the stock market is reeling from rising interest rates and the word recession keeps coming up regularly. Investors are searching for safety and bond yields are on the rise.

Will Bonds Outperform Stocks?

The question is will bonds outperform stocks? The answer to this question is possibly in the short term but very unlikely for the long term. As interest rates continue to rise eventually the inflation rate will come down, and the target inflation rate that comforts our government is between two and three percent.

If bond rates continue to rise while driving down inflation, the very rare situation of having better than average returns with low risk could happen. With the stock market whipsawing up and down as it has most of this year investing in the safety of bonds with low risk starts to look very attractive. Ultimately if bond yields hit double digits and inflation is below 3% you have the closest thing to a free lunch. So in that situation would you go all in on bonds and ditch stock holdings?

My Recommendation

No, I would never recommend a portfolio consisting of just bonds (or bond funds), but a well-diversified fund will have up to forty percent bonds. My personal preference has been low fee well diversified exchange traded funds which hold domestic and international stocks as well as bonds.

That bond component is meant to provide stability when the stock component of your fund goes through its short term down cycles. Eventually in the longer term when stocks outperform bonds again you’ll have been rewarded with a win-win as bonds will have added to your returns during the down cycle.

Many investors loathe holding bonds and despise the fact that bonds are, well boring. But in a diversified portfolio bonds will occasionally surprise you with excellent returns achieved with below average risk.

Water BarrelThe BalanceIn my E-books (“Water Barrel” and “The Balance”) I discuss simple methods to live sensibly for today, take charge of your financial affairs, and invest safely for the long term. For more information please visit David Penna Amazon.

As always, I am not a qualified financial advisor. I just relate financial management to my own experience which may not resemble yours at all. Advice is frequently worth exactly what you paid for it. Most of mine came from expensive experiences.

Leave a comment