The Hidden Dangers of 'Safe Investments' That Could Cost You Big

hey what's up everyone and welcome to the school of personal finance so a few weeks ago I put out a video talking about how to diversify the equity the stock piece of your portfolio and today what I want to talk about is the bond portion of your portfolio this is considered to be the more stable safe piece of your portfolio and with all the craziness going on in the world right now people are looking for ways to protect their money right they are getting tired of watching these markets go down every day but the last thing that I want to happen to you is for you to get blindsided by the safe piece the bond piece of your portfolio because bonds in themselves could be very risky depending on the types of bonds that you own and most people don't understand how bonds work they could be very complicated so all I'm going to try to do today is simplify it for you make it so that you could actually look at your statement to see what you're invested in so you can make some decisions around that and at least feel comfortable with how your current allocation is at the moment all right I hope you find this one helpful let's get to it all right real quick before we get started I am getting closer and closer to launching my educational membership group check it out at schoolofpersonal finance.com i'm going to be doing live webinars i'm going to have pre-recorded courses i'm going to have a community where you can come in and ask questions we can talk to each other in there and I'm also going to have live office hours where you could drop in on Zoom and ask me any questions so go check it out i would love for you to join all right so I think the easiest way that I could lay this out is if I go through different investment options that you might see in your 401k or your 403b plan and talk about how they work so that you can make the determination is that what you want is that what you're looking for all right so I'm going to start with what is considered the safest option in your retirement plan or in a brokerage account for example and that would be a money market fund so now I'm not talking about bank accounts like FDIC insured savings accounts at your bank or money markets at your bank or CDs at your bank those are the most secure things because they're FDIC insured and there's no fluctuation you know exactly what you're getting the interest rate might change right depending on what rates you're doing but you're not at risk at losing money all right money markets within your retirement plans or within the brokerage accounts are similar they have a rate of return that they pay you're not going to lose money in those even during the great financial crisis you know people were worried about are my money market funds going to disappear is the money because it's not FDIC insured could I lose money in those and it didn't happen then i don't see it happening now or anytime in the future right those are pretty safe and secure and they're usually invested in short-term treasuries and things like that but with the money market accounts you're not going to see fluctuations in your principal what you can see are fluctuations in the rate of return so like from a year ago money market accounts were paying a little over 5% where now they're paying a little bit over 4% and all the big institutions offer them so like you know the Vanguard money market fund or Schwab or Fidelity they all offer their own version of a money market mutual fund and that in your retirement accounts it's probably going to be the safest option that you have you don't have to worry about losing money the rate might change as time goes by depending on what the environment is but at least you know that your principal is safe and secure all right and then to go out a little bit further on the risk spectrum your plan might offer a short-term bond fund now this might include like 1 to 3 month or sixmonth treasury bills that are under the hood of that bond fund now with these bond funds they are pretty stable because the shorter the duration the shorter the period of time that you are locking your money up in those bonds the less they fluctuate depending on interest rates but you still can lose money so with bond funds when interest rates go up it has an inverse relationship so when interest rates go up the value of the bonds go down but when they're shorter term bonds they don't fluctuate nearly as much as longer term bonds and when you think about it there's a very simple reason for this let's use a simple example let's say that interest rates are 4% and you own a three-month bond all right or you own 100 3-month bonds inside of a bond fund right it's a fund of all these individual bonds and let's say the rate goes from 4% up to 6% all right that would be a very big jump in rates if you own all these bonds and they're currently paying 4% nobody wants your 4% bond right nobody's going to buy your bonds from you because they could go to the marketplace and they could get 6% bonds so in order for somebody to want to buy your bonds you would have to offer them at a lower price to make up for the difference that 2% that they could get just by going to the marketplace so now if you have only six-month bonds or a short-term bond fund where there are 3 months 6-month bonds in there then it's not that big of a deal because you only have to hold on to them for a short period of time and then you could reinvest in the newer higher rate bonds so they're not going to fluctuate in price all that much if interest rates go up and same thing on the way down right it's the inverse if interest rates go down your bond fund won't go up that much in value because those rates are going to expire when those bonds mature in 1 to 3 or 6 months or whatever the case may be when you go out for longer term bonds right that's where you see big fluctuations because if I have a 30-year bond and interest rates go up on the 30-year from say 4 to 6% I'm locked in for 30 years at 4% right i'm stuck with that where if I just go to the marketplace I could go buy a 6% 30-year bond nobody's going to want your 4% bond so if you wanted to sell it the only way you're going to buy it is if you offer somebody a discount that is going to give them the equivalent of being able to earn 6% right so if that bond is worth $1,000 you might have to sell it for $800 in order for somebody to make up that difference in order to get that 4% where it's the equivalent of a 6% bond so again just high level of how bonds work and it's a little bit confusing you might have to listen to that over again but once you wrap your head around it it actually makes sense and it's pretty simple so longer term bonds are much more volatile because you're locked in for such a long period of time so if they go against you then you're stuck with that bond for 30 years or if you want to sell it so that you could then take that money and reinvest it in something that has a higher rate of return then whoever is buying it from you they're going to require that you sell it to them at a discount at a lower price you're going to take a loss on that or else they would never buy it from you when they could just buy it out in the marketplace at a higher rate of return at a 6% yield hopefully that makes sense all right so next would be what's called an interim bond fund and you could have an interim government bond fund or an interim corporate bond funds and the only difference is that fund either invests in government bonds issued by the Treasury or they invest in corporate bonds issued by corporations and again corporate bonds they usually pay a little bit higher of a yield because they're a little bit riskier right a company could go out of business and then you're not getting your money back the money that you lent them that's what a bond is you're lending them money and they're paying you interest on it so now an interim bond fund is going to hold hundreds of bonds and they're usually going to have a duration or a time frame of say 5 to 10 years or so so now you're going out a little bit further on the yield curve which means that the prices of your fund might fluctuate more depending on what interest rates do so if interest rates go up then the value of your bonds they go down they become less valuable for what we just talked about before so you can lose money in an interimterm bond fund right if interest rates for example go from four to 5% if they go up one full percentage point your bond fund could go down depending on all the individual bonds that are in there and how long the duration is of those bonds you could see a 5% decline in your bond fund right so just because you hold an interimterm bond fund you can't think like this is totally safe and secure because what if rates go up by 2% right if the 10-year yield goes I mean it's been going up recently right so right now it's around 4.45 in that ballpark as the time I'm making this video if it goes up to 6 and a half% if we see a 2% rise in the 10-year your bond fund your interimterm bond fund could drop 10% 12% and that's a big hit so if you have $100,000 in there your $100,000 it could go down to 90,000 88,000 you will still get interest on that bond fund right there's two components there's the interest that it pays but then there's also the principle right is it going up and down the value of the actual bonds that are inside of the fund and then we go to a longerterm bond fund these might be bonds that are going to be 30 years up to 30 years 20 to 30 years and a 30-year government bond right now is paying around 4.9% right so that's tempting because you say to yourself "Wow I could get an interest payment of around close to 5% per year i like that idea i'm going to go with that one." But the reality is if that 30-year bond goes from 5% up to 7% or 8% and you're it's a 30-year that's a long time right your bond fund is going to fluctuate tremendously so in that long-term bond fund in that scenario where interest rates rise 3% you could be down 15% or more in your bond fund and that is a tough pill to swallow i don't know if everybody remembers 2022 that was a miserable year for everybody especially for financial adviserss because there was nowhere to hide so if you were managing money for people it was a pretty crappy year trying to explain that yes we had money in bond funds which is supposed to be stable and be the anchor in the portfolio when stocks are doing poorly but the stock market was down like 22% and bonds depending on what type of bonds you owned in there they were down you know double digits so it was a bad year overall for your investments and then you might have funds that are offered that are called high yield bond funds and typically you know we used to call those a long time ago we used to call them junk bonds they don't call them that anymore now they call them high yield bonds but the higher the yield the riskier the investment so if it's a high yield bond fund that that means that it is investing in companies that have a little bit more risk to them so you require a higher rate of return to invest in those and those are going to fluctuate especially if they are a long-term high yield bond fund those are going to fluctuate the most out of anything so if you put all of your safe and secure money in a high yield bond fund you might wake up one day to a big surprise thinking "Wow I thought I was being safe for this portion of my portfolio and it's down double digits." And I don't want that to happen to you so hopefully all of this makes sense right as you go through the different types of bonds and the duration of the bonds that are inside of your bond fund and how they all work together now just to be clear I am not giving investment advice at all here i'm just trying to explain how it works i'm not suggesting that you move money out of risky assets or out of the market into money market accounts right that totally depends on your portfolio your time horizon and your risk tolerance all that good stuff i just want you to understand what the safe part of your portfolio actually looks like and if you want to make a decision to get safer that you're making the right decision and that you're not putting yourself at risk when you don't even realize it all right everyone that is it for this one i hope that you found that helpful please leave a comment down below let me know that you liked it hit that like button share this videos with others if you think that it will help them out come join my membership group it's going to be awesome i can't wait to get rolling with it i will be sending out emails if you're not on my email list jump on my email list i look forward to seeing you over there and I will see you again in the next video thanks