The primary goal of fixed income investments is to generate income, specifically in the form of interest income. Unlike other investments, such as stocks, where capital gains and losses are realized upon selling the position, fixed income investments focus on generating regular income separate from any price changes.
While fixed income investments can be traded to take advantage of price fluctuations, a significant portion of the profit potential does not necessarily require exiting the investment position. This sets fixed income investments apart from other investment types.
When investors purchase stocks for long-term capital appreciation, they hope that upon selling the stocks in the future, they will realize substantial returns that outperform more conservative investments. However, if the investment incurs losses, which is always a possibility, it would be considered a failure. Holding a stock until a predetermined future point, based on factors other than market conditions, exposes the investment to the maximum amount of risk.
Many traders implement stop-loss orders in their trades, which act as a predetermined price point at which the trade will be exited. If market conditions deteriorate to the point where the trade is deemed unsuccessful, the stop-loss order is triggered.
For example, if a trader expects an instrument to break out from a trading range but instead experiences a significant movement in the opposite direction, the trade’s initial premise has been violated. Setting a stop-loss order helps limit the trader’s risk to the stop price, with a possible allowance for market slippage, which is the potential for the order to be filled slightly beyond the stop price due to market conditions.
Distinguishing Long-Term Goals: Stocks vs. Fixed Income Investments
With a buy-and-hold strategy, investors often choose not to set any market-based conditions on their investments and continue holding them regardless of market fluctuations, except for non-market-based criteria like retirement. This approach is based on the belief that stocks will eventually increase in value over time.
While this approach is not entirely unreasonable, it is crucial to consider the opportunity cost of investments, evaluating how other investments may have performed over the same period. In this context, fixed income investments provide an opportunity to eliminate market risk from the equation, which is a concern for many stock investors.
Fixed income investments, such as bonds, offer the option of holding them until maturity, earning a guaranteed interest rate over the bond’s lifespan and receiving the principal back. Although there may be fluctuations in the capital value of the bond depending on its market price at the time of purchase relative to its par value, these fluctuations are known upfront.
For example, if a bond is trading at 5% above its par value, it implies a capital loss of 5% at maturity, and investors can assess whether the return over the bond’s life will sufficiently compensate for this loss.
Therefore, with bonds, the entire investment picture can be clear from the beginning, with no uncertainties other than the risk of default if the bondholder holds it until maturity.
One of the primary goals of fixed income investing is to eliminate market risk by holding investments. By doing so, investors can substantially reduce overall risk, especially with highly secure fixed income investments like treasuries. Although the upside potential is limited to the yield of the instrument, which includes the interest rate and potential price adjustments, it offers a less risky alternative to buy-and-hold strategies with stocks. Furthermore, the overall risk can be minimized or even reduced to virtually zero by investing in the most solid fixed income instruments.
While investors can choose to actively manage fixed income positions and seek capital appreciation through timing strategies or even short positions in bonds, these actions are optional since one can simply hold the investments without the need to sell based on market conditions.
In comparing stocks and fixed income investments, the more inclined an investor is to invest for the long term, the more beneficial it is to consider bonds as a significant component of their portfolio. This allocation helps manage risk effectively and aligns with the objective of long-term investment strategies.
Utilizing Fixed Income Investments for Portfolio Balancing
The concept of diversification plays a key role in reducing or eliminating market risk in an investment portfolio. By balancing the growth component, represented by stocks, with the income component, consisting primarily of bonds but also including preferred stock, investors aim to mitigate potential drawdowns.
If an investor’s entire portfolio is invested in the stock market and the value of their shares declines by 50%, the overall portfolio value would also experience a 50% decline. This may not be a significant concern if the investor plans to hold the stocks for a much longer period, such as 10 or 20 years, and expects acceptable returns over the investment’s lifespan.
There may be instances when being fully invested in the stock market is preferable, particularly during periods of prolonged bull markets when expected returns are favorable. However, predicting the long-term future of the stock market at the time of investment is extremely challenging.
Regardless, stock investments come with inherent risks, and these risks manifest themselves in the returns realized when selling the stocks, rather than through drawdowns during long-term investments.
Leveraged positions can present substantial drawdown risks, where a certain decline in value can lead to a complete loss of the position. If an investor is leveraged at a 2:1 ratio and the stocks decline by 50%, they can potentially incur significant losses.
By investing in stocks without leveraging or using margin, most of the drawdown risk is mitigated, and the primary concern shifts to the possibility of the company going out of business. In this case, the focus is not on how low the stock price may go, but rather the price at which it can be sold later, assuming the investor stays committed and rides out market fluctuations. If the portfolio value declines during this period, the key consideration is how it may impact the overall outlook when it comes time to sell.
By allocating a certain percentage of investment funds to fixed income securities, such as bonds, investors can reduce the impact of adverse stock market movements to a level they find acceptable. For example, if 50% of the portfolio is invested in stocks and the remaining 50% is allocated to bonds (assuming bond prices remain stable), a 50% loss in stock value would result in only a 25% overall portfolio loss.
While bonds may also experience declines in value, their stability tends to be higher than that of stocks during bear markets. This is attributed to the intrinsic value of bond interest payments, which provides greater stability to bond prices.
The Goal of Reducing or Eliminating Market Risk
The market dynamics driving stock prices are primarily influenced by supply and demand. Stock prices are heavily influenced by market sentiment and investor perception, making them subject to fluctuations based on market conditions. On the other hand, bond prices are primarily influenced by interest rates. If there is a large-scale sell-off in the bond market, it creates an opportunity for other investors to step in and capture the increased yield that results from lower bond prices.
The perception of stocks being a bargain when their prices decrease is subjective and dependent on the market’s recognition of the additional value. With bonds, the creation of value is more predictable and can be mathematically calculated based on interest rates and yields.
Historically, stocks have outperformed fixed income investments in terms of long-term average returns. Stocks have averaged around 10% returns, while fixed income investments have yielded lower returns, typically around half of the stock market’s performance. However, managing risk is equally, if not more, important than managing returns. Allocating assets allows investors to determine the level of risk they are comfortable with, ranging from high-risk strategies focused on volatile stocks to low-risk strategies centered on holding U.S. treasuries until maturity.
Generating income is another goal of fixed income investments, as they offer a more reliable source of income compared to stocks. While some investors rely on dividend income from certain stocks, these dividends are generally less reliable than the interest payments received from bonds or preferred stock. Holding common stock for the long term exposes investors to the full impact of market risk.
While fixed income investments are commonly sought by older investors seeking to reduce risk and increase income stability, they are not limited to a specific age group. Allocating a portion of one’s portfolio to fixed income investments can be a prudent strategy for investors at any age.
