Common Bond Buying Mistakes to Avoid
Investing is a complex issue. It is not just a matter of throwing in money and pulling on a lever to churn out multiplicities of it. If the markets worked that way, there would be no losers and there would be no market. But because there will always be more losers than winners, the markets flourish and reward the few who are careful. In this article, we will look at the common mistakes that many investors make when buying bonds, and how to avoid them so you end up on the winning side.
Taking Excessive Risks
This has to come top on the list because it is simply a no-brainer. The golden rule of investment in any financial market (and bonds are certainly not exempt) is never to take too much risk. But what happens a lot of times is investors assuming risk that is way beyond the capacity of their accounts to handle, and beyond their risk appetite. There are certain factors that individuals must consider before assuming a type of investment.
For example, those who are nearing retirement and who suddenly discover that they have probably not invested or saved as much over the years, get tempted to assume more risk than is necessary in an attempt to make up for the lost years. They turn to bonds as the saviour, being the fixed-income and probably “safest” investment that there is, and decide to fling all risk considerations out of the window. Now because they are out to max out all their investments in the bond market, they jump into high-yield bonds or bonds of untested markets. Some investors even decide to jump in just because of the name brand of the bond issuer. Many investors probably do not know that the higher the yield of the bond, the more likely it is that the bond will never get repaid. Eventually, many of these investors lose their money, and the more they lose, the more desperate they get and the cycle repeats itself all over again. The lesson here is never to take more risk than you should. Consider your circumstances, your finances and capacity to absorb losses before jumping into a bond investment.
Buying Purely on Yield Information
Higher yielding bonds are more risky because of the high probability of default. The safest bonds are the ones with the lowest yield. Indeed for most average Joe investors in the bond market, there is simply no reason to be buying high-yield, high-risk bonds. If such investors are seeking higher returns, then in all honesty, they should not be in the bond market. They are better off in higher-yielding markets like the spot forex and options markets. Buying bonds based on which ones will give the largest returns is a common mistake that bond buyers should avoid making.
Non-diversification/Improper Diversification of Bond Purchases
Many average bond buyers have a warped idea of diversification. They probably think that diversification means maintaining different bonds in different accounts. Consider a case where an investor has bond brokerage accounts with three different brokers, and probably has bought bonds of an investment bank in one account, a commercial bank in the second account and a mortgage bank in the third account. Is such an account diversified? The answer is no. Even though the accounts hold three different bonds, they are bonds of companies in one sector of the economy. If a systemic problem crops up that causes the entire sector to collapse (the way the subprime mortgage crisis hit Bear Stearns and Lehman Brothers and eventually the financial services sector in 2008), all the investments in the three accounts will collapse. Notice how the subprime mortgage crisis (affected mortgage banks), eventually spread to the commercial and investment banks who were exposed to that sector in the form of loans, guarantees and direct investments, and the entire financial services sector eventually got hit all over the world. A truly diversified investment would purchase bonds in several unrelated sectors, probably include some foreign bonds, and with varying maturity dates. The investor may even decide to buy some callable bonds which can be sold ahead of their maturities, and mix them up with date-to-maturity bonds. Having such a mix in one account provides a better diversification of bond investments than holding several accounts that are used to purchase bonds from a single sector, or bonds with common characteristics. So non-diversification of bond purchases is just as bad as improper diversification of bond purchases. Traders should therefore get proper investment advice on how to diversify their bond investments.
Wrong Assumptions About Investment Payouts
Many traders enter bond investments with the wrong assumption that they will always get paid on maturity. Fact is, nothing is assured 100% when it comes to investments. That is why it is always important to purchase bonds after thorough analysis. It is possible for a company to delve into an unfamiliar business that is different from its core competency and problems with the new venture could create a big problem with the entire group. There are loads of examples of companies who have seen their financials badly undermined by non-performing new ventures/products. Similarly, political unrest in a country can negatively impact its credit ratings. This is why traders should also include date-to-call bonds in their portfolios, so that they can easily jump ship when the tide turns for the worse.
Adopting a Do-it-Yourself Approach to Bond Investing
Professionals are there for a reason: they know what the layman does not know and try as hard as you can, you can never be more of a leopard than a leopard. They are there to guide you and use their professional insight and knowledge to help you. Trying to save money on professional fees by going it alone is a bad gamble. Eventually, you could stumble into an investment issue that will prove too much for your level of expertise, and you may rack up in losses, much more than you would have had to pay a professional bond investment advisor for sound advice. The world operates on a principle of giving and receiving. If you hoard giving money to investment advisors (they need to make a living too), you will eventually hit a bad losing streak.
Don’t make these bond buying mistakes.