When you own stocks, you know their prices will always fluctuate. To help ease the effects of this volatility on your portfolio, you could add other types of investments, such as bonds. Yet bond prices will also rise and fall. But there may be - in fact, there should be - a big difference in how you view the ups and downs of stocks versus those of bonds.
Any number of reasons can cause stock prices to go up or down. But in the case of bonds, prices go up and down largely, though not exclusively, for one reason: hanges in interest rates. Suppose you purchase a bond that pays 4 percent interest and then, a year later, newly issued bonds pay 3 percent. You could now potentially sell your bond for more than its face value because it provides more income to investors than the new bonds. Conversely, if newly issued bonds pay 5 percent interest, the value of your existing bond would drop because it's unlikely that someone would pay full price for a bond that provides less income than newer bonds.
When you own stocks, or stock-based investments, you want their price to rise because you probably plan on selling those stocks someday - and you'd like to sell them for more than you paid for them. But it's not so cut-and-dried with bonds. While some people may indeed purchase bonds in hope of selling them for a profit before they mature, many other investors own bonds for other reasons.
First, as mentioned above, owning bonds can be a good way to help diversify your portfolio. Second, and probably more importantly, people invest in bonds for the income they provide in the form of interest payments. And here's the good thing about those interest payments: They'll always continue at the same level as long as you own your bond, except in the rare case of a default. (Although defaults are not common, they can occur, so you do need to take a bond's "credit risk" into account before investing.) Thus, if you plan to hold your bonds until they mature, you don't have to worry about a possible drop in their value. But if you need to sell your bonds before they mature, the price you receive will depend on current interest rates.
You can't control or predict interest rates, but you can help soften their impact on bond prices by building a "ladder" of bonds with varying maturities. Then, if market interest rates rise, you can sell your maturing short-term bonds and purchase new ones at the higher rates. And if market rates fall, you'll still have your longer-term bonds working for you at higher rates. (Usually, but not always, longer-term bonds pay higher rates to compensate investors for incurring inflation risk over time.) Keep in mind, though, that the investments within your bond ladder should be consistent with your investment objectives, financial circumstances and risk tolerance.
Whether you own your bonds until maturity or build a bond ladder, you can do something to protect yourself from price movements. And that type of control can prove valuable to you as you chart your course through the investment world.Ê
Brian Humphrey is a financial consultant and investment advisor.