Friday, January 17, 2014

My Investing Philosophy Part 2

This Part 2 blog entry will cover my approach to diversification and bonds.

Diversification is simple concept epitomized by sayings like "don't keep all your eggs in one basket".  If you rely on a small number of investments, your return could be hurt badly by a few random events.  For example, if you owned 10 stocks and one was BP, you could lose a lot when they had a big oil spill in the Gulf of Mexico.  On the other hand, if you owned 100 stocks, and the same unpredictable event occurs, the effect would be small, and might be offset by a positive event in another stock, say the announcement of a lifesaving drug by a drug company.  You also reduce your risk by combining different types of investments.  If you had a 50-50 split of bonds and stocks last year, you would likely beat an all-bond investment mix by around 15%.  So diversification reduces risk and I won't go much further into the different types of risk.  My investments are diversified as follows (this is a pretty conservative allocation).

Bond investing to me is rather straightforward.  Bonds give you income with lower risk since you are first in line to be paid by a company before the equity (stock) owners.   Typically, bonds return less than stocks but are less risky.  In the USA, there are three factors that drive bond investments for the average investor.

  1. It is costly to find and acquire individual bonds.  Bond ETFs and mutual funds are available with very low expenses.
  2. You can save on taxes if you buy Municipal Bonds in your taxable accounts versus regular government or corporate bonds.  Otherwise, you pay full state and federal income tax on bond income.
  3. Indexing gives you low costs, lower risks, and diversification (see Part 1).
So I typically keep index mutual funds with taxable bonds in my IRA and 401K and municipal bond index funds in my taxable accounts.

Disclaimer: these are my opinions and I accept no liability for the content of this blog, or for the consequences of any actions taken on the basis of the information provided in the blog.

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