Investing in Bonds: Three Steps to Smarter Bond Investing

Investing in Bonds: Three Steps to Smarter Bond Investing
by Alexander Green, Investment U Chief Investment Strategist
Monday, March 5, 2012: Issue #1722

At our Oxford Club Chairman’s Circle conference at The Ritz-Carlton in Naples last week, I noted a decided optimism about the outlook for the bond market. This enthusiasm is almost certainly misplaced.

We’re at the tail end of the biggest 30-year rally in bonds the nation has ever seen. Recall that three decades ago, Fed Chairman Paul Volcker pushed the prime rate all the way up to 21.5% to squelch inflation. Long-term Treasury yields reached 16%. But from that pinnacle, long-term yields have plummeted to around 3% today. Bond prices have soared accordingly.

It isn’t just unlikely that today’s bond buyers will see annual double-digit returns going forward, it’s mathematically impossible. And yet I sense that many fixed-income investors don’t understand this.

It’s not unusual to meet an investor who has plunked money in a bond fund because “its long-term track record is excellent.” They don’t seem to realize that it’s also irrelevant. Never has the old saw, “Past returns are no guarantee of future results,” been more apropos.

This doesn’t mean you should avoid bonds altogether, of course. But if you’re going to buy bonds, now more than ever you need to be smart about it. Here’s what you should do:

1. Ladder your maturities. You should buy two-year, five-year and 10-year bonds. If rates go up – as they will eventually – your bond prices will fall, temporarily. But you will get your principal back at maturity and be able to reinvest your principal at higher rates. And paltry as bond yields are today, they still beat the heck out of the 0.05% that the average money market fund is paying.
2. Keep a close eye on expenses. In the world of fixed-income investing, keeping a Scrooge-like eye on expenses is essential. Why? Because it’s difficult to work magic in the button-down world of fixed-income investing. Managers rarely earn their fees. And 12b-1 fees can eat away at your returns like termites in an antebellum house. My advice is to stick with individual bonds, Vanguard funds (whose expenses are one-sixth of the industry average) and low-cost ETFs.
3. Avoid leveraged bond funds. Ever wonder how bond yields can be so low and yet the yield on your closed- or open-end bond fund is higher, even after expenses? Open your eyes. Unless you’re holding junk bonds, your fund manager is using leverage, the fixed-income equivalent of buying stocks on margin. By borrowing cheap, he or she is leveraging the portfolio to add yield. This works just fine while bond prices are flat or rising. But when bond prices fall – as they will when interest rates rise – these shareholders will take a shellacking. Consider yourself forewarned.

Some fixed-income investors tell me they feel safe for now since Bernanke has pledged to keep interest rates low through 2014. Think again. The Fed has only announced its intention to keep rates low. (Future economic conditions could quickly change that.) The Fed is also keeping long-term bond yields artificially low by buying these instruments to goose the economy.

Inflation could tick up. The Fed could raise rates and/or quit buying long-term Treasuries. In the end, the Federal Reserve sets short-term interest rates, but not bond yields and prices.

Know this. Understand it. And act accordingly. Bond investors today should be in a defensive posture, capturing higher yields than what’s available in cash instruments, but prepared for that point in the future when bond yields will rise and prices will fall.

Good Investing,

Alexander Green

Why Stock Investing is Like Skiing

Why Stock Investing is Like Skiing
by Alexander Green, Investment U Chief Investment Strategist
Friday, February 24, 2012: Issue #1716

Over President’s Day weekend, I took my family to Massanutten Ski Resort in the beautiful Virginia Mountains. (It’s not Telluride, but when you have an eight-year-old son who yells “Woo-Hoo!” all the way down the slopes, it really doesn’t matter.)

We had admittedly low expectations for skiing when we arrived. It’s been an unusually warm winter and the snowfall has been virtually nil. Yet the night before we skied, the snow dumped fast and furious on top of the base of artificial snow.

The next day we woke up to a winter wonderland. Everything was covered with snow. The sun was shining. And it ended up being a perfect day. I couldn’t help thinking this was a lot like the stock market.

Here’s what I mean…

As well as being the Chairman of Investment U, I’m also the Chief Investment Strategist for The Oxford Club – a private fellowship for investors trying to achieve and maintain financial independence.

And our club has won numerous industry awards for editorial excellence. (The independent Hulbert Financial Digest ranks us among the top-performing investment letters in the nation for 10-year performance.) Yet much of our success actually comes from being well positioned to take advantage of completely unexpected circumstances.

Right now, for instance, the nearly two dozen recommendations in our Oxford Trading Portfolio are up an average of 43%, even though our average holding period is just 188 days.

Our portfolio is beating the market by a wide margin for two primary reasons:

• The first is that we have a proven system for identifying great companies at attractive prices.

• The second is that we don’t try to time the market. So when it suddenly puts on an impressive rally, as it has over the last three months (tacking on more than 1,500 points), we’re set to enjoy the benefits.

I don’t have a crystal ball. And neither does anyone else. Three months ago, we couldn’t have told you that the market was about to power higher. And two weeks ago, when I made my reservations for a mountain villa at Massanutten, I couldn’t have known that the skies would suddenly open up. But in both cases, it did.

Of course, stocks might not have rallied and the snow might not have fallen. But at least we took a chance. Successful investing is about hedging your bets, taking intelligent risks and being prepared for whatever happens.

Folks who wait for that mythical day when the investment landscape looks perfect will regret it. Just as those who wait for ideal conditions before planning a ski trip will find the fares are higher, the lift lines are longer or, if they wait too long, the snow is already gone.

Market bears will counter that the conditions may look right today, but that can change quickly. I don’t disagree. But we’ve thought about that, too.

We own plenty of investments outside the stock market, so our performance isn’t based on equities alone. We abide by strict position-sizing rules to limit our risk. And we run a trailing stop behind all of our stocks, assuring ourselves that our profits don’t slip through our fingers.

It’s not a perfect system, but it works, delivering high returns during the good times and protecting capital during the bad ones.

It sure beats sitting at home… wondering if it will snow.

Good Investing,

Alexander Green

A Solid Investment Strategy For a Shaky Market

A Solid Investment Strategy For a Shaky Market

by Alexander Green, Investment U’s Chief Investment Strategist

Monday, June 6, 2011: Issue #1528

As you may have noticed, the stock market is acting hinky again. That makes now a good time to review your investment foundation.

Here’s what I mean…

We keep past issues of our Oxford Club Communiqué – which includes our Trading Portfolio – posted on our website. A few months ago I received a letter from a new Oxford Club member who went back through the past couple of years and was astonished by what he found.

“You were heavily invested in top-performing stocks before the financial crisis, then went totally into cash early in the meltdown, then profited from the enormous market rebound that followed. How in the world did you get it so right? How did you know what would happen?”

The short answer is we didn’t know, never will know and neither will anyone else.

What will happen in the future to interest rates, currency values, and stock prices is always an open question. This is especially true when you throw in unforeseeable geopolitical events, thousands of pages of government legislation (and their unintended consequences) and a large dollop of fear, greed, and hope.

Accept the truth. You will never know what the future holds. And that’s okay because you don’t have to…

Taking Advantage of Stock Market Uncertainty

What you need instead is an investment system that allows you to take advantage of the uncertainty inherent in the markets.

Start by looking back at history. You’ll notice two important things.

1. Owning profitable businesses is the best way to preserve and build wealth.
2. Over the past two hundred years, the stock market has gone up more than three-quarters of the time.

Over the long term, shareholding is a winning game. Trying to time the market’s ups and downs isn’t. So we buy great companies – those we believe will post the biggest earnings surprises in the months ahead – and don’t worry about the tone of the market.

Protect Winning Positions With Trailing Stops

Yes, bear markets (which are normal) are nasty and will take your stocks way down. We don’t want that to happen. So we don’t let it. Instead, we carefully protect our winning positions by using trailing stops. As long as our holdings are trending up, we’re happy to stick with them. But when any stock pulls back 25 percent from its closing high, we bid it adieu.

That’s exactly what happened in the financial meltdown a couple years ago. When things started coming apart at the seams, our trailing stops protected our profits and raised cash. By October 2008, we had sold all 44 positions in our portfolio for an average gain of 28 percent. (Not bad for a year when the S&P 500 fell 36 percent).

Since we are not market timers, we started gradually rebuilding our portfolio and were able to profit handily all over again. We currently have 27 positions in our Oxford Trading Portfolio. Twenty-five of them are profitable. And our average short-term gain is 43 percent.

Yet here’s what millions of other investors did over the last few years instead:

• They watched their profits evaporate and didn’t buy much while things were cheap.
• They panicked, switched to cash and missed the rebound or
• Worst of all, they rode their stocks down, panicked and sold, waited too long to invest and only recently bought back in. Now they’re starting to feel nervous again.

Get Rid of the Fear and Anxiety of Stock Market Investing

Fear and anxiety are natural when you don’t know what the heck you’re doing with the money you intend to live on some day. But you can get rid of the fear by dumping an investment approach that doesn’t work.

Please understand, we couldn’t possibly have known how everything was going to unfold. And neither could anyone else. But we used – and still use – an investment system, for our Oxford Club subscribers, that allows us to profit in good times and protect our capital in the bad.

Now that the market is acting jittery again, the question to ask yourself is “Am I using a system that allows me to capitalize on the uncertainty that is inherent in the markets? And, if not, why not?”

Good investing,

Alexander Green