ANÁLISIS DEL PROYECTO GEF-TCA

Bonds.

People who are serious about their financial future will save and invest for specific goals, such as the down payment for a house, college costs for children, and retirement. Each of these goals requires one or more expenditures at specific times. It is wise to think of a separate fund or portfolio for each because as the time for each expenditure approaches, an adjustment in the composition of the specific portfolio often makes sense.

As we pointed out in elements 8 and 9, a portfolio based on a diverse set of equities (stocks) has been the best way for most savers to build wealth over time. That has been a sound investment plan in the United States for at least the past two centuries. A key feature of any investment plan, however, especially one based primarily on equities, is the ability to stick with the plan and ride out the ups and downs of the market. The stock market, after all, is volatile. The long-term trend has always been up, but it can move quickly up and then very quickly down, in an unpredictable fashion. And it can stay down for months or even years. As the need to spend approaches, the ability to ride with the market through a fall and into the recovery declines. Moving gradually from stocks to the bond market, which is generally less volatile over periods of less than ten years, can reduce as the time approaches when you will need the cash. You will avoid the need to sell large portions of your stock at an unusually low point in the market.

Moving to bonds reduces, but does not eliminate, risk. The greatest risk of owning bonds is inflation, which lessens the value of both the principal

and the fixed-interest payments. However, that risk can be reduced or eliminated with the use of “TIPS,”or Treasury Inflation-Protected Securities. This product is a form of Treasury bond that was first sold in 1997. TIPS return the principal, a fixed-interest rate that depends on the market rate when they are purchased, and an additional payment to adjust for in- flation. Because unanticipated inflation is what makes bond payments worth less than expected, buying and holdings TIPS will protect the holder against that risk. TIPS are particularly attractive for retirees seeking to generate a specific stream of the purchasing power from their assets. An additional risk associated with bonds is the impact of changes in in- terest rates. Assume that you buy a USD 1,000 thirty-year bond that pays 5 percent interest. This promises to pay you USD 50 in interest every year for thirty years, at which time the bond matures and you get your USD 1,000 back. But if the overall or general interest rate increase to 10 per- cent soon after you buy this bond, then your bond will immediately fall in value to about one-half of what you paid for it. At a 10 percent interest rate, an investor can get USD 50 in interest every year by buying a USD 500 bond, so that is about all anyone will be willing to pay for your USD 1,000 bond. Of course if the interest rate drops to 2.5 percent soon after you buy your thirty-year, 5 percent bond, then its price will approximately double in value. But this is more volatility (or risk) than you want to take if you are saving for something you expect to pay for in five years. Given a five-year horizon, it is much safer to buy a bond that matures in five years, at which point you receive all of your USD 1,000 back. As a general proposition, when buying bonds you should buy those that ma- ture at about the time you expect to need the funds, since you get the face amount of the bond back at maturity no matter what the interest rate is at the time. Because large changes in interest rates are usually the result of changes in inflation, TIPS protect against much of the risk associated with interest-rate changes.

How long should a portfolio consist of stocks, and when should the move to bonds be made? That depends on the length of time for the investment.

Relatively short-term investments may do best in bonds exclusively. For example, a young couple saving to buy a house may be better off avoiding the stock market entirely — for that portion of their savings only — and investing it in bonds. That is because purchasing a house or condominium often involves saving for just a few years. In contrast, a couple might save for eighteen years to finance a college education for a new born or for thirty-five to forty-five years to build up savings for their retirement. In these two cases, equities should be an important part of, or perhaps the entire, investment fund for most of the saving years.

The parents of a newborn who begin saving right away for the child’s college education have more years to build the needed wealth and to reduce the risk of using stocks to build it faster as well. Financial writer James K. Glassman points out that when real returns to an equities fund account are 7 percent over the eighteen years it might take for a child to be ready for college, a USD 300-per-month investment can yield USD 150,000 in the eighteenth year. Even at the rate that college tuition and fees have been increasing, that should be enough to cover room, board, tuition, and fees for a good state university. You should note that waiting until the child are six years old to start saving for the same result will double the needed monthly investment to USD 600. Again, it is important to start saving programs as early as possible.

Glassman’s numbers assume tax-free build up of the investment, and the new “529 college saving plans”— which are state-sponsored plans — allow this. The web site of TIAA_CREF, a respected investment firm, notes that a 529 College Savings Plan is “a state-sponsored, tax-advantage savings plan that can help families and individuals save for higher edu- cation. These plans offer a number of benefits including federal tax-free withdrawals for qualified expenses, tax deferral of earnings, professional money managements, and the flexibility to use the proceeds at virtually any higher institution.”The plan allows investors to buy into mutual funds for a diversified, long-term (and thus less risky) investment that should maximise the returns for the ordinary investor. As the time for college ap- proaches, however, you should reduce risk by changing the portfolio in

the plan gradually from stocks to bonds, especially TIPS, which are likely to fluctuate far less in value over a few years’ time.

As people earn more and live longer, saving for retirement expenses be- comes ever more important. We don’t want to drastically, and negatively, alter our lifestyle upon retirement; and we cannot afford to outlive our retirement nest egg. For the saver whose retirement is more than ten years ahead, a diversified portfolio of stocks, such as a mutual fund indexed to the S&P 500, probably makes the best investment portfolio. For the more conservative saver, having 10, 20, or even 40 percent of one’s portfolio in bonds will offer some peace of mind, even though total returns will probably be lower in the end. The value of bond holdings will not fluctuate as much, month-by-month or year-by-year.

As the need for retirement income approaches, it may be prudent to begin to switch an all-stock portfolio gradually into bonds. When that switch should begin will depend partly on when the money will be needed but also on how much will be needed in the near future. For those with a large portfolio or a good pension income relative to their retirement in- come needs, much of their savings can be left longer in equities to max- imise the total return. The goal of switching to bonds is primarily to avoid the need to sell stocks at temporarily low stock prices. The more dependent you will be on selling those stocks for monthly living expenses, the more important it is to reduce risky by moving gradually into bonds. Once again TIPS may well be a good choice.

James Glassman summed up his advice to future retirees in the following manner: “Risk tolerance and personal needs vary, but the principles re- main: Start early, take advantage of tax breaks such as the 401(k) plan and IRAs and stick with diversified portfolio of stocks for the long run.” This is a sound advice.