Since we bought this blog, we have written some interesting posts about asset allocation for beginner investors. However, knowing what the difference is between fixed income and the stock market is hardly enough to know how to invest your hard earned money!

This is why we are taking a closer look at how to invest in fixed income asset classes today.

First Fixed Income to consider: Government Bonds and CDs

Government Bonds and certificates of deposit (CDs) are the safest investment products you can use to build your portfolio. However, they are also the least flexible. Picture a bond or CD as you are the banker and not the borrower:

The principle behind this type of investment vehicle is that you are lending an amount of money to either a Government (Country, state or city) or a bank. Since you want your money back, you are lending your money to them for a specific period of time (called the term). Then, you don’t want to lend money for free (no one does this anyways?), so you will do it at a fixed rate of interest (called the APR).

Why bonds and CDs are less flexible investments?

Now go back to your usual borrower’s mind for a second: how would you feel if the money you have borrowed could be called back (i.e. the lender asks to be reimbursed right away) at any moment? You would probably not feel comfortable borrowing money from this person. This is the same way it works when you are lending money to the government or a bank; they want to make sure they have enough time to pay you back.

This is why it is usually harder (read very hard in the case of CDs) to break your contract and cash out your money before the end of term. You will usually have to suffer a penalty which would result in less interest paid to you than the original contract. In this time of very low interest rates, you certainly don’t want to see it reduced to even less than that!

Good news; there is a secondary market for bonds

While I mentioned it was harder to get your money back from CDs before the term expires, it is because you are dealing alone with the bank. However, there is a market (similar to the stock market) to trade existing bonds. This is where you can buy or sell existing bonds on the market. However, this doesn’t mean that your money will be guaranteed if you sell your bond before it matures (i.e. at the end of the term).

Why money invested in bonds is not guaranteed before the end of term? Isn’t it the safest investment?

Picture this: 5 years ago, you bought a 15 year government bond paying 5% interest rate. Today, after the rate goes down, you still earn 5% interest while new bonds issued in 2010 are giving 3.5% (I’m not using real numbers by the way…). Why would you sell your bond that is giving 1.5% more than anything else on the market? Answer: at the same price you paid for your bond, there is no way that you will sell it unless you really need money.

Then picture this second situation: You buy a bond today paying 3.5% for 15 years. In 5 years from now, interest rate rises and the same bonds (i.e. the same issuer) will pay 5% for new issues on the market. How can you sell a 3.5% bonds when anybody can buy a new bond with the same level of security but giving 5%?

There is an answer to both situation and this answer is found on the bond market: When you buy new issue, you buy it at a price of $1,000 per bond (i.e. if you have $10,000 to invest, you will buy 10 bonds). If the interest rate goes up in the future, your bond is less attractive since it is paying a lower coupon (3.5% vs. 5%). Since you have the option to sell it anyway, investors on the market will pay you less than $1,000 for the same bond. Since at the end of the term they will get back $1,000, the difference between what they pay (let say $975) and what they get at the end of the term ($1,000) will compensate for the lower rate (3.5%) that they will be earning in the meantime.

The same math applies if you have a high paying bond and the rate goes down; your bond will be worth more than $1,000.

This is why your fixed income portfolio can go negative from one quarter to another while your capital is secured . This often happens if you buy bond ETFs  or mutual funds invested in bonds. So there is no reason to panic, you just have to hold your bonds long enough to get your capital (and your interest) back!

Author: Mike.

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There are a lot of interesting quotes talking about the stock market. My favourite one is definitely:”You should buy when there is blood on Wall Street”. I really like the analogy of this quote since it doesn’t only tell you that you need to invest when everybody is running away from the stock market (to buy bond funds) but it also tells you how scary it is to be a contrarian.

Since March 9^th, 2009, the S&P 500 has soared by 70%. While the 2008 credit crunch was the most brutal drop of the index, 2009 showed us the most incredible rise of the S&P 500 of its long history.

According to the Investment Company Institute, 24.6G$ exited the stock market since the beginning of 2009. During this very same moment, 455.6G$ (yup, you read right, 455G$!) were invested in bond funds. While the interest rates were at their lowest level ever, it was the worst time to buy bond funds!

You might have been burnt by the market but it doesn’t mean that you should hang yourself with bonds

I understand the logic where investors who lost 50% of their portfolio twice in the same decade (remember the techno bubble with Nortel, JDS Uniphase and Cisco plummeting?), thought they could not get burnt a third time. However, investing in a bond fund is probably much worse than looking at proper investing strategies (with a sound asset allocation!).

I’ll explain this in another post, but just keep in mind that the value of bonds drop when interest rates increase. Therefore, if you buy a bond fund, your portfolio value will drop at each interest rate increase (note that it already started in Australia and Canada where their central banks have started to increase their prime lending rate). So if you fled the stock market to buy a bond fund, you are doing it at the perfect moment to lose what is left in your pocket…

Rational vs Irrational

The biggest problem is that people always think the same thing: “I’ll come back to the stock market when it’s back up”. What is the point? You will have lost the opportunity to make money? I was granting leverage loans (borrowing to invest) from 2003 to 2007 and the peak of investing came in 2006-2007. People wanted to invest more and more money in the stock market based only on the fact that “it was going up”.  Therefore, they invested with little knowledge and a very bad investing strategy (getting a quick profit out of a few trades).

Those very same people tend to sell everything when it goes bad and whine that they lost a lot of money in the stock market. This is why they are looking for bonds as a safe haven. However, when interest rates start rising, they will lose money again, ironic, isn’t?

The rational approach is to invest in the stock markets when it is low (like right now). In a few years we will look back at what just happened and we will say that it was obvious to determine the right time to invest (2009-2010). In fact, we will say the very same thing we said back in 2004-2005 when we looked at the crash of 2000-2001…

So stay invested and concentrate your efforts on a good investing strategies instead of trying to make the trade of the year or keeping all your money safe in a low interest money market fund…

Dealing with increased volatility has now become a part of investors’ daily routine. As of 2008, the stock market has become the  most volatile we have ever seen, some have even taken to calling them “violent”. I guess this is why most people have fled the equity scene to invest more in fixed income choices and don’t want to hear about investing in the stock market. However, the stock market was, is and will be the best place to encourage your investments to grow.

There are several types of investment to consider when you want to purchase a piece of a public company. Today, we will be reviewing the most common asset classes related to stock. We will take a look at how we invest our money into them in a later time.

What is a Stock anyway?

In order to gather cash to finance business growth, companies basically have 3 options:

#1 They borrow money from a bank like an individual and offer guarantees to back the loan.

#2 They borrow money from the markets (by issuing corporate bonds). This is very similar to borrowing from the bank but individuals or other companies are creditors instead of a normal bank.

In both these cases, the company has to manage a defined interest rate and its accompanying repayment schedule. Sooner or later, it will have to pay back the debt.

#3 They issue shares (usually a small part of the corporation) and sell them to the public (through the stock market in an IPO: Initial Public Offering). Therefore, each individual can buy a tiny part of a company through the purchase of stock. Shareholders (those who have purchased the company’s stock), will gain benefit from:

#1 the company growth (as the stock will be worth more and they can generate a capital gain by selling)

#2 through dividends (the company may decide to share their profits with shareholders instead of reinvesting them).

So when you buy stocks, you actively participate in the growth of a company while it doesn’t have to pay you back. You are buying a part of a company in the hopes of seeing it make more profit in the future so you can sell it with a profit of your own.

The great news is that you are no longer limited to buying companies from your own country. You can also buy foreign companies (such as BMW that is not listed on the US market for example).

International Stocks

International stocks are a great option if you want to diversify your portfolio and hold companies that are not directly influenced by the US economy (which is still hard to find since the US consumer makes the world economy turn…).

However, you can benefit from another country’s economy that will make the company grows faster. Just think about the Canadian market and their banks. Investing in Canadians banks is certainly something to consider these days…

However, you must keep in mind that it adds an additional risk; currency risk. Since you are buying foreign country companies, you have to buy them in another currency. For example, you take $1,000 to buy Canadian Banks in Canadian dollars and the US dollar goes up. Your $1,000 Canadian dollars may only be worth $900 in US dollars down the road. Even though your investment is still worth $1,000 (i.e. it didn’t lose its value on the stock market), if you sell it and convert your money back, you will lose $100.

Emerging Markets

Emerging markets is a really interesting asset class. They are more commonly known as the BRIC (Brazil, Russia, India and China). To those emerging markets, you can add Venezuela, Turkey, Vietnam, etc.

These are countries with strong but unstable economic growth. Since companies are growing at a ridiculous pace, it is hard to predict their long term stability. This is why you can get a very nice yield overtime but the fluctuation of your portfolio will be greater than what you would experience on the US market.

Nonetheless, it is interesting to have a part of your portfolio invested in emerging markets.

Questions about the Stock markets? Please send me an email at thefinancialblogger (at) gmail (dot) com.

I’ve been reading your comments from my giveaway post where I was asking what you wanted to read about on Green Panda Treehouse. Many of you expressed the interest to read more about asset allocation and how to invest savings at a young age.

So I decided to start an “asset allocation series” that will describe which kind of asset classes you may choose to invest in and how to manage your asset allocation depending on your age, financial situation, investment goals and, most importantly, how you sleep at night with your asset allocation (i.e. tolerance for risk). This will probably be a lengthy series since there is so much to read about. This is why you will have an “asset allocation post” about once a week and they will be regrouped in a special section of this blog.

You want to learn how to manage your asset allocation properly? You first need to know which kind of asset classes you can invest in! Today, I’ll first review the major asset class categories and in a second post, I’ll subdivide each of them, but let’s just start with a definition of asset class and asset allocation:

Asset class definition:

“Asset allocation is the strategy used in choosing between the various kinds of possible investments, in other words, the strategy used in choosing in what asset classes such as stocks and bonds one wants to invest.

A large part of financial planning consists of finding an asset allocation that is appropriate for a given person in terms of their appetite for and ability to shoulder risk. This can depend on various factors; see investor profile.” (wikipedia)

Asset allocation definition:

“Asset allocation is the strategy used in choosing between the various kinds of possible investments, in other words, the strategy used in choosing in what asset classes such as stocks and bonds one wants to invest.” (wikipedia)

Asset class #1: Liquidity

This is probably the most simple asset class you can invest in: CASH! Your liquidity can be found as pure cash in your investment account, in a high yield savings account (such as SmartyPig), in T-bills (treasury bills with maturities less than one year out guaranteed by the government of a country) or in a money market funds (a fund where the manager trades different t-bills and short-term notes in order to generate a higher yield).

This asset class is used for transactional purposes. If you want to invest money in another asset class, you will need use your liquidity. Therefore, the objective of this money is to get the highest yield possible considering 2 major factors upfront: #1 capital security, #2 capital liquidity.

Asset class #2: Fixed Income

The fixed income part of your investment portfolio will be the part where you will keep your “safer” investments that generate regular income. It doesn’t mean that this money will be 100% guaranteed, but this is the next safest asset classes. By safest, we often mean the one with least volatility (fluctuations in current value). As they will rarely show a supercharged yield, they will rarely drop by 20% as well. Since you have several types of fixed income, I’ll let you discover them in another post of this series.

Asset class #3: Stocks

If I have to make an analogy, I would compare the fixed income as the body of your car that will protect you and put everything together and I would compare stocks as the engine and fuel of the car.

Stocks are issued by companies so investors can “own” a very small part of the company. For example, if you buy 100 shares of Apple (this will be quite costly ), you will own something like 0.000001% of the company . If the company goes well and shows strong financial results, your stock will increase in value since the company will be worth more overall. There are several ways to invest in the stock market, some riskier than others. We will take a look at them later on.

Asset class #4: Others

Believe it or not, there are tons of other asset classes! While most investment products are covered between fixed income and stocks, you can also go into more complex products such as linked notes, derivative products such as options or commodities (oil, gold, copper, crop, etc.). I’d say that using those other asset classes require more investment knowledge. However, I will still show you how you can participate in those asset classes without running into a brick wall!

If you have any specific questions regarding asset allocation, please comment below. I’ll include the answers to your questions in my upcoming articles.