Tuesday, September 3, 2013

Building Bonds

When the lay public thinks of Wall Street and high finance, they invariably think of the stock market. And when mainstream news shows report on the economy, they'll always have some throwaway line about the Dow Jones Industrial Average or maybe even the S&P500 like "The Dow closed 150 points up today. The S&P 500 was up 13 points".

And stocks are risky. Even if you diversify your stocks into hundreds of companies, if all you own are stocks, it's considered a very risky investment portfolio. The primary reason is because stocks represent a claim on future profits. So if there are no profits, there's nothing for stocks to return back to the investor.

This is where the bond market comes into play. The bond market is completely invisible to the average person. They have no idea what it does and the pivotal role it plays in the economy. And this is problematic. If you combine the values of every stock market in the world, you get a nominal value of about 55 trillion dollars. That is a phenomenal sum of money. And yet, it's much smaller than the total value of the international bond market, which is 157 trillion.

The bond market is so much more important than the stock market, yet few have any idea it exists. This is a real problem because it prevents people from learning how to invest properly. Very few people in the US save a significant amount of money for investment purposes. And the majority of those who do plow all of their money into stocks and stock funds. And that's a huge mistake.

As you grow older, return on investment becomes much less important than capital preservation. Stocks have a higher growth rate in the long term, but in the short term, they are subject to wild price fluctuations that bonds simply don't have. A bond is simply a promise to pay back money. And that money comes from revenue, not profits (revenue - costs). That's why it's a much safer investment class than stocks.

When you listen to the political discourse that revolves around the privatization of Social Security, it inevitably attracts simplistic rhetoric like "how can you trust your retirement to something as risky as the stock market? Did you live under a rock in 2008?" And that works because most people don't have a concept of bond markets, which soared during the financial crisis and beyond.

President Obama wants the Federal government to educate people about the relative value of colleges. But if he wants to improve the average American's life, he'd be better off if he could educate them on the value and importance of the bond market. Because there are plenty of people out there who don't trust the stock market because they've been burned too many times in the past. But the much more stable and gentler bond market would be right up their alley.

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