Bonding your portfolio: Diversifying investments, large or small, will minimize risks

Key Points

One of the most challenging financial decisions you need to make these days is where to put your money. Whether your investment portfolio is large or small, you must choose from among mutual funds, individual stocks or bonds, or simply stashing away your cash in bank accounts, money market accounts or other cash equivalents.

In today's volatile economy, experts agree that diversifying among those choices is absolutely essential. By spreading your investments across the various categories, you minimize your chances for major losses in any one category.

For example, when stocks fall in price, bonds will usually rise, and vice versa. That's one of the reasons why bonds have a place in almost every serious investor's portfolio.

Since it's likely that you will dedicate a portion of your investment portfolio to bonds, it's important that you keep yourself aware of the peculiarities inherent in bond investments.

While bonds of all types - government, municipal and top-rated corporate - are generally considered safer than investments in securities, they are not entirely risk-free. Except for U.S. Treasury bonds, there is always the possibility (though rare) that any one issuer will be unable to meet its obligations to pay interest and principal.

By choosing bonds of different types, you will minimize that risk even further. Another option for the bond investor is to stick with bond mutual funds, thus guaranteeing broad diversification.

Since the price of bonds is tied inversely to current interest rates, the market value of bonds will fall when interest rates rise.

This is not a problem for the long-term bond investor, because the bond's interest payments will remain the same regardless of fluctuations in market price, and the full face value of the bond will be paid when it matures. This is why it's best to limit bond investments to money that you're investing for the long term.

If preserving your principal and earning interest is your primary financial goal, a buy-and-hold strategy is essential. When you hold a bond to maturity, you will receive interest payments, usually twice a year, and receive the face value of the bond at maturity.

If you want to maximize your interest income from bonds, keep in mind that you will usually get higher interest rates on longer-term bonds. With more time to maturity, long-term bonds are more vulnerable to ups and downs in interest rates. However, those fluctuations will not affect you unless you find it necessary to sell your bonds.

Risks

Like all other forms of investment, bonds have their own set of disadvantages and risks. Sometimes, you may find it necessary to sell bonds that you bought as part of a buy-and-hold strategy.

When you find it necessary to sell a bond before maturity, you may get more or less than you originally paid for it. If interest rates have risen since you bought it, its value will have declined. If interest rates have gone up, the bond's market value will have increased.

Brokers

Among the lesser-known considerations in the purchase of individual bonds is the markup the buyer pays to the broker. Bond brokers aren't required to reveal their markups, the commission-like fees they charge the buyer.

In a typical transaction, a broker buys a bond at one price and sells it to the buyer at a higher price. The difference is the broker's profit on the transaction.

On the other hand, when brokers buy bonds from you, they employ the opposite technique, charging a "markdown" - paying the buyer less than the broker received from the sale.

Because most bonds aren't traded on an exchange like stocks, bond buyers have no way of knowing what the prevailing market price for a given bond is without shopping around. If you buy bonds from a broker, you will need to find someone you trust to charge a "fair" markup.

The National Association of Securities Dealers requires only that markups be "fair" - an unfortunately vague requirement. While most brokers aren't likely to abuse that opportunity, it's important that you deal with a broker whom you trust.