Risk is a constant in investing. After all, no one can predict the future with perfect certainty, meaning that no one can say that something will work out exactly as they expect. Of course, some things are much riskier than others. For example, the chances of a small start-up defaulting on its debt obligations can be quite high. In contrast, the chances of the U.S. federal government defaulting on its debt obligations are quite low, so much so that if it happens, chances are good that everyone will have something much more serious to worry about than the state of their investment portfolio. Based on this, it should come as no surprise to learn that there is a wide range of methods used to manage risk in investing, with an excellent example being diversification.
For those who are unfamiliar, diversification means putting a mix of investments in an investment portfolio for the purpose of risk management. Essentially, the intent is to make sure that the bad performance of some investments will be countered by the good performance of other investments, which is why it is so important that the investments are not perfectly correlated with one another. This is one reason that counter-cyclical investments see so much use.
Should You Diversify Your Bonds?
By investment standards, bonds are pretty predictable. As a result, diversification isn't as useful for bonds as it is for stocks, which are a much more unpredictable kind of investment. On top of this, even though diversification can be used to reduce the risk of bonds, there are other risk management methods that can be used to achieve the same aims. For instance, buying a wider range of bonds can reduce the potential harm of a bond issuer defaulting on its debt obligations. However, interested individuals can do the same by predicting whether a particular bond issuer will be capable of honoring its promises or not within the lifetime of the bond, which is much easier than predicting whether a stock price will go up or go down at a particular point in time.
Having said that, it would be a shame to not diversify bonds. To an extent, this is because bonds are one of the best ways for interested individuals to diversify their investment portfolios. After all, bonds aren't very correlated with other kinds of investments, meaning that they aren't very susceptible to the same issues. In fact, it is worth mentioning that bonds can even be negatively correlated with stocks, which explains why the two are so often paired together even in the simpler investment portfolios.
In any case, there is an even better reason to put bonds together with other kinds of investments, which is that bonds aren't as rewarding as a lot of the other options out there. They are predictable. Unfortunately, that very predictability is considered very appealing to interested individuals, meaning that bonds don't need to offer returns as high as a lot of other kinds of investments. As such, people can't expect high rewards by investing in bonds and nothing but bonds. Yes, investing in other kinds of investments will mean more risk, but the very presence of bonds will reduce that risk to some extent. Moreover, it is worth mentioning that long-term bonds have become less valuable in recent times, thus cutting off one potential option for people who want to profit through bond investing.
How Should You Diversify Your Bonds?
Investing in a wider range of bonds would be one way of diversifying bonds. However, investing in other kinds of investments would be another way of diversifying bonds. The two are not mutually exclusive, so it is perfectly possible to engage in both at the same time.
In any case, choosing investments for the purpose of diversification is still reliant on what interested individuals have in mind. Due to this, they need to set certain criteria for the kinds of bonds that they are interested in based on their investment goals. This can refer to the expected return on the bond. However, this can refer to various other criteria such as their length, their issuer, and their potential risks. Be warned that introducing new kinds of bonds can introduce new kinds of risks even as they serve to mitigate existing risks in the investment portfolio. For instance, some people might be curious about foreign bonds. Such investments can be very useful, but there is an important matter in that foreign bonds mean foreign currencies, meaning that interested individuals will need to factor in foreign exchange risks as well. People are welcome to take on new kinds of bonds with new kinds of risks, but they definitely need to remember that this will mean an increased expenditure of effort on their part if they want to remain on top of everything.
As for the kinds of investments that can be paired with bonds, the classic choice with stocks. Once again, interested individuals can set criteria such as the size of the corporation, the volatility of the stock, the reasonableness of the stock's value based on the corporation's earnings, and so on and so forth. After which, they can use a stock screener to look for stocks that match their criteria before using their own sense of judgment to examine the candidates further. Choosing stocks from multiple sectors is a good way to ensure that the entire lot won't get devastated by the same economic trend. Similarly, it is important to keep the percentage of stocks at a reasonable level relative to the bonds to preserve the latter's risk-mitigating value.
Having said that, there are plenty of other investments that can be paired with bonds. For example, a lot of people are interested in the upsides of real estate properties. However, if they don't care for the considerable hassles that come from actually owning and operating real estate properties, there is a simpler solution in the form of buying shares in REITs. Similarly, there are other options such as junk bonds and emerging market debt. Be warned that investing in these kinds of investments come with extra risk, particularly since they are less familiar to the aforementioned bonds and stocks. As such, investing in them through a reliable and reputable fund might be a more careful way to benefit from them without taking on too much risk in the process.
Written by Allen Lee
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