What's Your Allocation?

Studies have shown that a very large driver of variation in returns for portfolios is derived from different asset allocations.  Focusing on having the right asset allocation can help improve your returns on investment over time and is a more reliable driver of returns than either stock picking or market timing.  There is often much debate over any "ideal" asset allocation as it differs among individuals.  I'll just go over some of the general themes and rules of thumb on how to think about asset allocation.

Falling Investor Confidence

With the end of the month finalizes the DOW's worst May since 1940, dropping almost 8%.  With worries in Europe turning toward Spain recently, market volatility has increased.  Facebook's IPO disaster recently also helped reinforce investor fears in risky assets leading to more risk aversion and avoidance of stocks altogether.

What's Your Grade?

What is the grade of your bond and how does that affect your investment?  The grade is an indicator of a bond's credit quality.  Just like how individuals have a FICO score for credit card companies to check the quality of a person, the grade of a bond is a way for you to check the quality of an institution's ability to pay back debt.  Standard & Poor's and Moody's are the two big names in the credit rating scene.  You can see from the handy chart that the more A's the better, kind of like in school.  The speculative and highly speculative ranges are known as the junk bond ratings where you are essentially taking a bet on getting your money back, but you will definitely get a larger return than from higher rated bonds.

These ratings are based on the issuer's financial condition.  However, it is important to remember that it is only one factor going into your decision to invest in a particular bond.  Some other factors to consider is the yield on the bond, whether or not it pays a coupon, if it is tax-exempt, or if payments are inflation adjusted.  The bond rating is useful for a quick check but as always, you should always do thorough research on the securities you are looking to purchase.  I may come back to discuss more about bonds, but hopefully the next few posts will look more at stocks.

The Name Is Bond...

Okay, so it's not really about James Bond, but I couldn't help but resist the cheesy pun.  It was either a picture of this or Barry Bonds, or I could have gotten a very boring picture of a certificate which is the type I will be discussing in this post.

So if you haven't already read the first post on bonds, I would recommend going there first.  This post will just take a more in depth look at what bonds are, the different types of bonds out there, and why you should consider investing your money in them.

As I mentioned in my first post, bonds are thought of as "safe" securities.  It is a type of debt investment: you are giving your money out as a loan and expect to be paid back in full with some interest for your trouble.  Bonds are used by governments, states, companies, municipalities.  This is where most of the risk lies with bonds, and like I mentioned in the other post, the payment of your bond depends on the reputation of the bond issuer.  With corporate bonds, these can be quite risky (some of the riskiest bonds are called junk bonds, implying that you would essentially be buying junk since it isn't that likely that you would get paid, but these bonds often have the highest returns).  In technical terms, these bonds are given a low rating.  I will make another post about the ratings later on and what you should watch out for, so for now assume that the bonds we deal with are guaranteed and safe.

Stocks and Bonds, What?

So you have some money saved up, probably from disciplined budgeting, and perhaps it's in your bank account.  What do you do with it now?  You are earning a little bit of interest, but you really want to see your hard-earned money grow, have it reproduce more of itself for you and take a little bit of the responsibility for your financial stability.  What can you do with it?  There are actually a lot of options available to you.

I'm fairly certain almost everyone has heard of stocks and bonds, but probably many college students don't know what they are or how to utilize them.  Please read the disclaimer at the bottom of my website as nothing I say will constitute financial advice.  I will try to state mostly facts and observations as well as give my own opinion, but if anyone reading this blog is actually thinking about putting money into any of the places I will mention, please do your own research to make sure any investments you make are right for you.  For this post though, I will be mainly defining a lot of these asset classes.

First of all, what are stocks and bonds?  First, let's look at the question of equity versus debt (stocks are a form of equity and bonds, debt).  Equity is ownership in something.  When you buy a stock, you are becoming a partial owner of the company and purchasing ownership.  Debt, on the other hand, is similar to the loans we have talked about for credit cards and banks.  When you buy bonds, you are loaning money to the entity on the other side.  If you buy government bonds, you give the government money and get a bond (a certificate that says the government owes you some amount of money) in return.

What is the difference in how these assets earn you money?  With equity, the value of your ownership depends on the performance of the company.  If you take some time to follow the stock market, you will see that it fluctuates day to day.  You can earn money through two avenues: capital appreciation of the stock (you buy the stock at one price and sell it at a higher price) or dividends (similar to interest you earn on debt).  For debt, you earn interest either when you get your principle back at the end of the term or as a stream of payments up until the end of the term.  It is kind of similar to how you pay interest on your credit card balance if you don't pay it off in full, except when you buy a bond, you are the one getting paid as the lender.

Bonds and debt securities are considered safer securities than stocks and equity because you are guaranteed your money back (depending on how reputable the bond issuer is).  Stocks do not have to guarantee a dividend and the value of a company can drop pretty steeply with some bad news.  However, with greater risk often comes greater reward, which I will discuss more in depth in my next post.