Welcome to How to Retire on Time, a show that answers your questions about all things retirement, including income, taxes, Social Security, health care, and more. This show is an extension of the book, How to Retire on Time, which you can grab today on Amazon, or by going to www.how to retire on time.com. My name is Mike Decker. I'm the author of the book, How to Retire on Time. But I'm also a licensed financial adviser, insurance agent, and tax professional, which means when it comes to financial topics, we can pretty much cover it all.

Now that said, please remember this is just a show. Everything we hear should be considered informational, as in not financial advice. If you want personalized financial advice, then request your wealth analysis from my team today by going to www.yourwealthanalysis.com. With me in the studio today is mister David Fransen. David, thank you for being here.

Yes. Glad to be here.

David's gonna be reading your questions, and I'm gonna do my best to answer them. You can send your questions in right now to 913-363-1234. Once again, that's 913-363-1234. Or email them to hey mike@howtoretyme.com. Let's begin.

Hey, Mike. Why do people put money in bonds and bond funds when equities do so well?

It's a great question, especially when you have and this is not meant to be demeaning, but short term memory. So the purpose of bond funds, let's be very definitional

Yeah.

For a moment.

Helpful.

Yes. Bond funds are not supposed to beat equities. They probably will never really beat equities over a long term period of time. The purpose of bond funds we're talking about bond funds, like ETFs or mutual funds that trade bonds. Okay.

We're not talking about bonds themselves.

Individual bonds.

That's a very important distinction.

Okay.

Bond funds are there to help protect you and not literally protect you, but help lower your risk downside risk. K? The problem is a lot of people have assumed that bonds and stocks are negatively correlated or as in if stocks go up, bonds go down, and if stocks go down, bonds go up. There's actually not a negative correlation.

Okay.

So let's let's break this down even further. So the theory behind it, and this was done by Harry Markowitz who got a Nobel Prize for this. Basically said, hey, you know, put 40% of your assets in bond funds. Maybe they'll average around 4 or 5% year over year. And 60% of your assets in stocks or equities because they have more growth potential and you want the growth potential.

But in the years that the markets would go down, typically when markets go down, they would drop interest rates. If you drop interest rates, then bond funds go up. Does that make sense? This is not a normal thing. Yeah.

If interest rates go down, bond funds make more money.

Yeah. I don't know why is that. Do we know?

There's a direct correlation with it. So think of it this way. This is my chicken analogy. Alright. I like chickens.

I like eggs. So here you go. Yeah. If you have a chicken that you're selling for $1,000 that's guaranteed to live for 10 years. Uh-huh.

And it's gonna give you 3 eggs every week for 10 years. K. You know exactly what you're getting. Right? Yeah.

Alright. Now imagine that science has a breakthrough and you can now buy a chicken for a $1,000. Okay. Same price, but you're gonna get 5 eggs every day or every week for 10 years.

Okay. Do

you wanna pay a $1,000 for a chicken that gives you 3 eggs?

I I wanna maximize my my return here. I want the 5.

You want the 5 eggs? Yeah. It's the same thing with the Fed's new rates. So if the Fed is currently offering 3 eggs or 3% and increases to 5, then your chicken that's offering 3 eggs, you have to discount it. You know, maybe sell it for, I don't know, $600 or something like that.

To offset what you would have missed by the extra eggs had you just paid the normal price for the 5 egg chicken. Now let's do the inverse. So if you're buying, let's say chickens that give you 5 eggs, it's kind of a funny analogy. Right? But you buy a chicken that's guaranteed to give you 5 eggs for 10 years, 5 eggs a week for 10 years, and now those chickens don't exist anymore.

They're all offering 3 eggs a week. The chicken that's offering 5 eggs for the rest of its 10 year life, they're more valuable.

Alright.

So they would increase in value.

Okay.

This is how basically bonds work. Now not not bond funds, but bonds. Yeah. So the value of your bond is compared to the current interest rates or the current offerings. Basically, is it a chicken giving you a lot of eggs or less eggs compared to what's been out there?

Uh-huh. Do you

see the difference there?

Yep.

So if the fed increases rates that means the new products, the new bonds are of better value and so everything else that's historical loses value because it's not worth as much. It's less competitive. And then the inverse. If the Fed drops rates then whatever has happened, it's more valuable until it matures then it's gone. So bond funds are actively trading bonds.

Alright. Right. So if you're a trader, if you're a bond trader. Okay, and the bonds you have are now more valuable than the new bonds, that helps increase your overall value of of the bonds. Okay.

The bond fund that you manage. Are you following me with so far with this?

Yeah. Absolutely.

People really struggle. This is the simplest version of it. There it gets much more tactical. But the idea is if you have a bond fund, okay, and the markets crash, so the equities have gone down. Okay?

The Fed is gonna try and rescue the market by making money cheap. The way the Fed makes money cheap or cheap to borrow against to try and bail ourselves out or to rip recoup from things is they drop interest rates. So it's cheaper to borrow money. If you drop interest rates, then bonds increase in value. So if bonds increase in value during a market crash, that increase can help offset some of your losses.

Okay.

That that's kind of in a very simple summary what Harry Markowitz was trying to explain, which won him a Nobel Prize. But people have over assumed that this will always happen. So in 2022, 2023, bond funds and equities or stock funds Uh-huh. Both lost money. And if you look at the last 120 years or so, there are many times where both bonds and stocks I should say funds.

So equities funds or stock funds and bond funds lost money together. And it can happen. The idea is to diversify with uncorrelated asset classes and the stock market is uncorrelated with the bond market. So because they're not correlated, it's a way to diversify. And the reality is there's plenty of markets.

There's really 6 markets if I'm to categorize it. You've got, cash and cash equivalents. So your high yield savings and money markets. You've got the bond market, which is largest market. You have the equities market or the stock market.

You have the insurance product market. You've got the real estate market, whether you actually have real estate or not. You've got, REITs. You've got Delaware statutory trust. There's other ways to invest in real estate.

And then you have the alternative market, which is its own thing unto itself. For most people though, they're not going into real estate. They're not going into alternatives. They're really trying to build a growth focused portfolio, but not take too much risk or not have enough risk because growth is equivalent to the risk you're taking. So the more risk you take the more growth potential you have.

That's why the bonds are in here. It's to help lower your risk overall. But if you add bond funds to your portfolio, you have less growth potential. Okay. You can't have it both ways.

Yeah. So when people say, well, hey. I've got the magnificent 7. You know, you've got Nvidia, Microsoft, Apple, Google, Tesla. That's a very concentrated portfolio.

It is.

They're all going up, but what if they go down?

Then that could happen. Right?

Yeah. So how much risk are you willing to take? And that's that's a pretty misunderstood concept of what risk is. Maybe we'll talk about it another time. But do you see this idea of, okay, people put bond funds not to make money.

Bond funds aren't gonna make you rich. They're there to help stabilize you and hedge against equities risk.

Yeah. That makes sense.

So here's just a couple of examples. Let's say you're a magnificent 7 investor and you believe you're really smart because you bought the magnificent 7. You've had a great couple of years.

Yeah. But if you

had followed that same philosophy, let's say in 2000, the dotcom crash, you had, Amazon was great. Google was a thing. I mean, all was a Google thing?

That was sort of mid 2000

That was mid 2000.

Yeah. Or506.

Let's see. IBM was a big thing. I mean, the dotcom. Boom. Right?

Mhmm.

So Microsoft was a thing there.

Oh, yeah.

So in 2,000, these equities just tanked. And if you look at the Nasdaq, I think it was down, like, 70% or something like that. I mean, it was harsh, but, you know, more where there's more growth potential, there's more downside risk. We just forget that that can happen. And if you look at look at Amazon, go go on Google or what's the other ones that are out?

Yahoo, Bing. I shouldn't be a preferential to Google. Alright. Right. Go online and look at what Amazon did.

For example, love Amazon. Great company. Great, you know, price. Great stock. I'm not saying you should buy Amazon.

I'm just saying that it's done well. But go on there and watch how much it grew until 2,000 and how it tanked and didn't recover for 10 years. What if your magnificent 7 starts to maybe go down and doesn't really grow for 10 years? That is a risk that you're taking. Whether you realize it or not, no one knows the future.

So am I saying you should sell magnificent 7? I'm not saying that. Am I saying you should sell Nvidia because it can't go higher? I'm not saying that. What I'm saying is put all your eggs in one basket, maybe an oversimplification that takes more risk than you may realize.

Because when it gets to retirement, it's not about how do you get rich and become the richest person in the graveyard. It's about staying rich. So a 20 and 30 year old, yeah, you could you could risk it. You could concentrate and try and take on that additional risk for more growth potential. But when you're when you're getting close to retirement, you might be right.

But are you okay with the possibility of being wrong and the consequences that would ensue? People say this word, oh, I well, I'm diversified, but I don't think they really understand what it means. So you don't diversify your assets to grow. Think of it this way. If you invest in a lot of different positions, there's a good chance that there's a lot of mediocre companies in there who maybe aren't growing but maybe they don't crash as much either.

They're just kind of steady Eddie boring. Some people like that. Some people are okay with the wild ride. If you want a wild ride, you're not diversifying from a broads perspective. You're hand selecting different positions and it could do great.

It could go down. And it could go down hard. We need to stop and this is such a difficult thing for the human condition, but stop falling for our personal bias of saying well this is how I think it should be because this is how you need it to be. Do you really need that growth? And what happens if it doesn't go like like as planned?

It's FOMO.

Okay.

Fear of missing out.

Mhmm.

People hate bond funds when the markets are on a tear going up. People love bond funds when the markets go down and interest rates go down because they they help offset it. I think the whole thing is just kinda funny because I I personally think in retirement, instead of bond funds averaging 4 or 5% around there, why wouldn't you just ladder out a bunch of CDs, treasuries, and fixed index annuities? If you do it right, they could have similar growth potential, but they can't go backwards. I think there's a more comprehensive or a more complete way to put together a portfolio that doesn't just rely on broad diversification in equities or stocks and bonds or bond funds, specifically.

I just think it's an oversimplified approach saying, well, this is the silver lining. We found the perfect balance for you.

Right.

On the ups and downs that you're gonna experience. It's I just have a hard time kind of swallowing that. Did I explain that okay? I mean, is this making sense?

It does. It does make sense. Then we we have the sort of the common wisdom that's been around for, I don't know, whatever, decades. Right? Stocks, bonds.

A stock and a bond just kinda you gotta have this much of that and that much of this.

I'm not quoting prices here. Okay. I'm not saying this is how it is. But what if just for example, you could find assets, products, investments that were protected couldn't go backwards but still had the same average growth moving forward. Why wouldn't you expand your investment horizon into other markets that maybe have some protection?

Maybe they don't have protection. They've got more growth potential. But expand instead of just opted into a a basic stock bond fund portfolio. There's so much more out there. But I but it's the it's the cliche.

It's what we're familiar with. It's what we're comfortable with. And I think that's why people oversimplify their strategy and end up relying on what I would call an incomplete retirement plan with an incomplete portfolio that does not hedge, again, in my opinion, appropriately against the flat market cycle or the market crash or the inflationary risk or, you know, fill in the blank. There are so many risks to to go on there. So going back to the question, why do people put bonds or bond funds in their portfolio when equities do well?

It's because and this is kind of the, the expression in the industry. It doesn't matter until it matters. Your bond funds are not really there for when equities are growing. They're there for when they don't. And no one can time the market.

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