MONEY Master the Game: 7 Simple Steps to Financial Freedom (49 page)

Boredom comes from a boring mind.

—“THE STRUGGLE WITHIN,” Metallica

Now, what if that same company offered me a 12% return to invest in that $2 million property—but for the better rate, it wanted me to loan it $1.5
million instead of $1 million? That would make the loan-to-value ratio 75%—obviously I’d get a greater return by taking a greater risk. It means if the market dropped by 25% or more, I might lose some of my investment. Not likely, but possible. So if I was willing to take the extra risk for an increase in returns, it might be something I’d consider. But I would not put this investment in my Security Bucket. It belongs in the next bucket you’re about to discover: the one that should be wrapped in yellow caution tape and handled with oven mitts, because if you approach it the wrong way, I guarantee you’re going to get burned! But handled effectively, it can speed up your journey to Financial Freedom.

By now you can see why asset allocation is an art, not a science. The idea of security is totally subjective. Some people think nothing is safe! Others can live with a tiny bit of risk and still feel secure. So you’ve got to look at each investment on an individual basis.

The real payoff of asset allocation comes when you figure out the right mix of how much of your money you keep safe and how much you’re willing to risk to get greater rewards and have the potential to grow faster. In investing, that’s where you live or die, succeed or fail. So what percentage do you think you should put in your Security Bucket—in safe investments? One-third? Half? Two-thirds? Failure to secure a significant portion of your hard-earned money in safe investments can spell financial disaster. Conversely, putting too much in this bucket can significantly slow your growth. How do we find the right balance? That’s what we’ve been working toward. And now that we’ve locked down the foundation for security, it’s time to
really
get in the game. It’s time to play to win.

As a quick note, bonds can be such a potentially important investment for your Security Bucket that I wanted to give you a quick bond briefing that might be well worth your review. If now’s not the right time, remember this is here as a reference for you, and skip over to the next chapter. Keep up the momentum! We’re on our way to bigger risks and potentially bigger rewards.

A FEW WORDS ABOUT BONDS

Gentlemen prefer bonds.

—ANDREW MELLON, founder of the Bank of New York Mellon

Not that long ago, bonds were supposed to be the safest, most reliable form of investment. They were the big guns in the portfolios of the ultrawealthy, and the bedrock of your Security/Peace of Mind Bucket for the average investor. But bonds have taken a bad rap in recent years, and for good reason. With the US government keeping interest rates insanely low, and some of the companies, cities, and even nations that issue bonds teetering on the brink—or even going bankrupt—they don’t seem like such a great deal to everyone anymore.

But most experts still think bonds are an important part of your investment mix. (In fact, they’re the foundation of the mind-blowing portfolio that works in all economic climates, which you’ll learn about in chapter 5.1.) So let’s look at the basic kinds of bonds out there to see what can be great about them—and also what to watch out for.

• US Treasury Bonds.
Many investment experts, including Yale’s asset allocation wizard David Swensen, feel that the safest bonds are good old US Treasuries, because they are backed by the full faith and credit of the government. David told me, “Treasury bonds are really there as an anchor for the portfolio.” But because these bonds are so safe from default, they have smaller returns. And like other, less secure bonds, they can fluctuate in price based on outside events—particularly how much inflation or deflation is happening at the moment. So suddenly what you thought was a bomb-proof investment can blow up in your face!

Treasuries come in four different types (and they have different names for how long they last to maturity).

1. 
T-bills:
These Treasury bills are government debt obligations that come due in less than 12 months. They are the basis for most short-term bond index funds and money market funds.

2. 
T-notes:
Treasury notes mature in one to ten years, and offer a fixed interest rate (known as “the coupon”). You get interest payments on these every six months.

3. 
T-bonds:
Same as T-notes, but Treasury bonds mature in ten to 30 years.

4. 
TIPS:
First created in 1997, these Treasury inflation-protected securities protect you against spikes in inflation. When you buy TIPS, the principal (or “par value”) of your bond goes up or down when the consumer price index on inflation changes—and so does your semiannual interest payment. So if you buy $10,000 worth of TIPS at 1.5% interest, and the CPI doesn’t change in six months, the “par value” of your bond stays the same, and you get a $150 interest payment. But—and here’s the beauty of TIPS!—if the cost of living goes up 2%, your bond is now worth $10,200, and your semiannual payment is $153. If you own a lot of TIPS, and there’s a lot of inflation, that money can add up! Here’s a chart that shows you how it works:

Notice that the value of the bond can be adjusted down, too. So if we go into another economic recession or depression, you could potentially lose some of your principal if you need to liquidate and get the value of your bond today.

Basically, if you buy TIPS, you’re betting that we’re heading into a period of inflation. Does that seem likely? If you’re not sure (and, really, nobody ever knows for sure), you may want to do what David Swensen recommends in his ideal portfolio: because TIPS go
up
in price when interest rates rise (which usually happens during inflationary times), balance them with an equal amount of traditional Treasuries that go
down
in price when interest rates rise. That way, you’re protected in any situation!

Of course, the US government isn’t the only country that issues bonds to pay for its operations. And in the good old days of a few years ago, a bond backed by the full faith and credit of a sovereign nation used to be considered a fairly safe bet. But now that we’ve had Greece, Spain, and other nations teetering on default—or, like Argentina, plunging over the edge—foreign government bonds have become a riskier deal. Foreign bonds are also more vulnerable to inflation risks, and if you buy bonds in an unstable currency, you might run into big trouble exchanging them back into dollars. Most advisors say to leave these investments to expert traders and hedge funds.

But what about some other bonds that can bring in better returns than plain old Treasuries? Some of the types listed below are safer than others. You can find out what others think about their prospects through a rating system that categorizes bonds by the level of risk to investors.

There are several internationally recognized bond rating agencies, such as Moody’s, Fitch Ratings, and Standard & Poor’s, that use special formulas to come up with credit ratings for different issuers—kind of like the way your credit is rated when you apply for a car loan or Visa card. For S&P, the grades range from AAA (the highest level of confidence that a company or country won’t default on its debts) to BBB (adequate for “investment grade” bonds), and all the way down to D (which means the bond issuer is already in default). The lower the rating, the more interest the issuer usually has to pay to bond holders for the risk that they’re taking. The expertly renamed
high-yield bonds,
formerly known as junk bonds, have a rating of lower than BBB, which makes them “subinvestment grade.”

• Corporate Bonds.
Corporations issue bonds when they want to raise money to expand, make acquisitions, pay dividends, fund a loss, or any number of reasons. Should you buy corporate bonds? It depends on
the risk. If you pick the wrong bond, you could lose most or all of your money. Even iconic companies such as TWA and Kodak have gone bankrupt. A year after it declared Chapter 11, Kodak’s unsecured bonds were selling for 14 cents on the dollar. But bonds from most giant US corporations are still considered safe bets. Apple (with an AA+ rating) has been selling high-grade bonds to eager buyers—but the interest those bonds earn is only about 1% higher than comparable US Treasuries! Some investors, like David Swensen, say, “Why bother with corporate bonds when you can get a better return just buying stock in the company?”

But if you’re looking for higher yields in bonds, you have lots of options—as long as these investments go into your Risk/Growth Bucket and not your Security Bucket! For instance, not everybody shies away from so-called junk bonds. You have to look at each one and decide if it’s worth the risk. In May 2014 Australia’s largest airline, Qantas, offered a subinvestment-grade eight-year bond in Australian dollars for a 7.75% interest rate. The company had its credit rating downgraded because of recent losses and debt problems, but would you count it out? Or at a more extreme level, in January 2013 in the midst of chaos, there were people who were
buying one-year Egyptian Treasury bills with a “guaranteed” (a guarantee only as strong as you think an unstable government can make) return of 14.4%.
Those who did this were betting that the US government and the Saudi Arabian government would keep Egypt stable and solvent.

Would the rewards be worth the risk of default? That’s the kind of decision you’d have to make before buying the junk bond.

Of course, not many of us have the experience or time to do this level of research. That’s where a talented fiduciary advisor who’s an expert in the area might come in handy. But there are also domestic and international high-yield bond index funds that can give you good returns while spreading the risk among many bonds.

• Municipal Bonds.
How about munis? When a state, city, or county needs to raise funds for a big public works project (sewer systems, hospitals, mass transit), it borrows money by issuing a bond. In the past, these
municipal bonds were considered a win-win deal for everybody, because the interest they paid was usually exempt from federal and possibly state taxes. But what’s been happening to cities and counties all over the United States? San Bernardino and Stockton, California? Jefferson County, Alabama? Detroit? Chicago? All bankrupt or on the verge, and their bondholders potentially left holding the bag. Doesn’t sound like such a sure thing anymore. Also, when interest rates drop, sometimes the issuer of the bond can “call” it in and pay back your principal before the bond matures. You lose that guaranteed rate of return you were counting on.
But once you acknowledge the risks, there can be some great opportunities in municipal bonds if you know where to look.
And the tax advantages can be outstanding.

Here’s an example that might prove valuable to you: a friend of mine recently bought a New York City bond where he’s getting a 4% return
tax free
—which, for someone in a high tax bracket, is the equivalent of an approximately 7% return in a taxable bond! Why isn’t he worried about the risk? These bonds are secured by a lien on future tax revenues. So if New York City gets into trouble, it has the ability to tax its way out of it and pay him back! He feels so good about this bond that he’s putting it in his Security Bucket!

The point is, there are plenty of municipal bonds that could be valuable for you—but you have to educate yourself and sit down with a registered investment advisor or some other knowledgeable investment expert who knows his or her munis.

Want to take the guesswork out of choosing the right bond mix for your portfolio? Vanguard founder Jack Bogle suggests buying into
low-cost, low-fee bond index funds that spread out your risk because you’ll own every part of the bond market.
You can see how Bogle puts this concept to work in his own portfolio in section 6, “Invest Like the .001%: The Billionaire’s Playbook.”

Now onward to greater risk and potentially greater reward.

CHAPTER 4.2

PLAYING TO WIN: THE RISK/GROWTH BUCKET

The winner ain’t the one with the fastest car. It’s the one who refuses to lose.

—DALE EARNHARDT SR.

The
Risk/Growth Bucket
is where everybody wants to be. Why? Because it’s sexy! It’s exciting! You can get a much higher return in here—but the key word is
can.
You
can
also lose everything you’ve saved and invested. So whatever you put in your Risk/Growth Bucket, you have to be prepared to lose a portion or even all of it if you don’t have protective measures in place.
How do we know this? Because everything in life, including markets, runs in cycles. There are going to be up times and down times. And anybody who invests in one particular kind of asset while it’s on a roll—be it real estate, stocks, bonds, commodities, or whatever—and thinks the party will last forever because “this time will be different” should get ready for a rude awakening. When I interviewed Jack Bogle for this book, he repeated one of his mantras: “Markets always revert to the mean.” (That means what goes up is going to come down, and vice versa.) And I’m sure Ray Dalio got your attention when he said that whatever your favorite investment might be, at some point in your life, you can count on it
dropping 50% to 70% in value
.
While there’s unlimited potential for upside in this bucket, never forget that you could lose it all (or at least a significant portion).
That’s why I call this the Risk/Growth Bucket and not the Growth/Risk Bucket, because growth is not guaranteed, but risk is!