Understanding Risk: The Role Of Bonds
Jeff Miller | Sep 27, 2013 02:54AM ET
What is the most important decision for the long-term investor?
This is actually an easy question, but most investors get it wrong. You need to choose the right level of risk!
Here are the key facts:
- Even in the best market years there is often a serious "correction" during the year. Since 1980, the average intra-year decline has been 14.5%. Every time there is a modest pullback you will see many warnings that this is the "big one." That is when most investors bail out.
- And of course there really are a few big ones.
Here is the helpful table via JP Morgan's this post where I explain how to quantify actual risks).
My basic solution is one that you can imitate. The Enhanced Yield approach serves as a bond substitute, reducing portfolio volatility while delivering 9% or so after commissions. It will do this in a sideways market, and it also has a lot less risk than a stock fund in a declining market. Examples of stocks that you could use if you want to try this at home are CSCO, INTC, MSFT (old tech works well), KSS (surprising retail strength), and DE. The key is valuation, a reasonable dividend, and picking a call that is out of the money and will return 10% annualized from the sale. Do not chase if the conditions are not right.
Whatever you choose as an anchor, do not be over-confident about stocks. If you are young and willing to ignore volatility, the prospects are good. For most people, the risk/reward balance is crucial.
[Long all named stocks versus short calls]
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