A low-risk portfolio is comprised largely of cash accounts and bonds, but few stocks, as stocks are considered the riskiest of the three (see this article for a finance glossary). Do not be deceived, there is some risk in bonds, and the risk is probably not what you think. There are many different types of bonds, some of which are riskier than others. Bonds issued by businesses are vulnerable to bankruptcy of the business. Bonds issued by the government are vulnerable to government recklessness in spending that leave it unable to meet its financial obligations, like so many European nations between 2008 and 2012. These types of risk are specific to the particular organization, and one would not expect all governments and all businesses to be unable to repay bondholders, unless a severe recession occurs (in which almost every investment sours, anyway). However, any type of investment that agrees to repay you a fixed number of dollars in the future is vulnerable to unexpected inflation. This is a fact people in war-time frequently learn, as well as Americans in the 1970's. Learn from their lessons, lest you learn the hard way.
German Inflation
Most of the "safe" investments are considered safe because an organization tells you exactly how many dollars it will give you at a precise point in the future, it tells you this in the form of a legal contract, and should the organization be unable to repay all its obligations, bonds and cash accounts are usually first in-line to receive whatever value is left. A bankrupt company usually has nothing left for its stockholders, and they lose one hundred percent of their investment.
However, this agreement to pay in a precise number of dollars introduces a different form of risk: unexpected inflation. Consider Germany after World War I. If Germany won the war, it had planned to punish the defeated countries by plundering their wealth. When they found themselves to be the defeated party, they discovered the allies had the same idea, and Germany was expected to make huge reparation payments to compensate countries like France for the toll the war had wrought.
It turns out that these obligations were simply impossible for Germany to meet. It could not make these payments and feed its own people at the same time. Because there was so little actual wealth to draw on, the new German republic felt forced to create artificial wealth by printing money. Lots of money. Unbelievable amounts of money. This is almost impossible to believe, but in just a few years after the war prices in Germany were one billion times their prewar level. People carted their money around in wheelbarrows, the currency was so numerous—and worthless. Some people even used the devalued Mark to light their stoves, and others used it as wallpaper (see 1923 picture below)!
Figure 1—The Worthless German Mark as Wallpaper
Not only did Germany owe money to the allies, but their own citizens as well. German citizens were confident they would win the war, and they eagerly invested in war bonds to pay for the war. They did not expect that their country would repay them by printing money, and when they were repaid the dollars bought far less than the dollars they lent. Vast numbers of people who had saved and invested their money wisely were financially wiped out. Those who were most prudent were the most devastated.
This is the reason the European Union is more conservative in their monetary policy than the U.S.—that is, they are less likely to print lots of money. Their central bank could have easily print money to stem the financial crisis in Europe between 2008 and 2013, but Europe knew the consequence of hyperinflation, and has no desire to relive the past.(E1)
And the responsible are betrayed: America, in the 1970's.
A similar, though far less intense event took place in the 1970's, after American went off the gold standard and could print however many dollar bills it liked. U.S. inflation rates rose to double-digits, which was rare for the U.S. Unfortunately for the most prudent of Americans, this high inflation was not expected (if it had been expected lenders would have required a higher interest rate to offset a devalued dollar). These Americans who thought they were making safe investments got repaid in dollars worth so little their savings were often wiped out.
Consider these remarks regarding this era of America, and promise yourself that you will keep some money in stocks so that you aren't "made a fool". You see, stocks are not directly impacted by unexpected inflation, because companies can simply charge higher prices when inflation ensues, and stockholders will receive higher dividend payments to help pay for higher priced goods.
Quotation 1—That 70's Era
To people who've worked their whole lives playing by the rules, that is, to the majority of adult Americans in the early 1970's, inflation at the hands of wayward government policy seemed to be a betrayal. People who had been thriftiest watched down payments for buying a home disappear, college savings accounts shrivel, retirement nest eggs vanish, the value of monthly pension checks shrink. Harvard Business School Professor Samuel Hayes recounted the damage to a relative of his in a magazine story: “He was the epitome of the Protestant Ethic. He had inherited money, he had saved, he was very frugal, had a very modest house, had part of his investment money in bonds and short-term securities, had always maintained liquidity. And he came out of the Seventies looking like a fool.”
—Real Clear Markets. June 10, 2009. "Why Inflation Is So Scary."
www.realclearmarkets.com. Also
quoted in The Wall Street Journal on June 12, 2009 in the "Notable and
Quotable" article in the editorial section.
Bond markets are bullies
Do not let this discussion lull you into thinking bondholders to be weak. The bond market is among the most powerful forces in the world. They can determine the outcome of wars, and can bully Austrian emperors.
The Rothschilds were a famous family of bankers in the nineteenth century. European history seems an endless stream of battles, and the Rothschilds accumulated substantial wealth by purchasing war bonds. Somehow, they seemed to know which country would win wars, and so they bought bonds from those who they believed would be victorious, and shunned the bonds of the defeated. How did they know which country would win? Largely because they collected valuable information and were adept at strategic decision-making. They had the same strategies and talents as the best investors today.
The Rothschilds did not only pick winners, but helped determine winners. Every European nation believed that if war arose, they would need to borrow money from the Rothschilds to finance the war. Whether one was victorious or not depended as much on the Rothschilds' patronage as it did the abilities of their armies.
Emperors and prime ministers relied on the Rothschilds so intensely that the Rothschilds were able to make demands of the nation before they would lend money, and the nations would oblige. Many believe it was the Rothschilds decision not to purchase bonds from Dixie that caused the South to lose the U.S. Civil War.
Quotation 2—Bankers rule the world!
"M. Rothschild knows Europe prince by prince, and the bourse courtier by courtier. He has all their accounts in his head, that of the courtiers and that of kings; he talks to them without even consulting his books. To one such he says: 'Your account will go into the red if you appoint such a prime minister.'”
—Ferguson, Niall. 2008. The Ascent of Money. Page 90. Penguin Books:
London, UK.
One demand the Rothschilds made was that they be repaid in sterling: the currency of the United Kingdom, where they resided). This meant the bonds had to state the amount of British sterling it would repay even if its own currency was something different. A Prussian Kaiser could not even issue bonds in his own currency!
An illustration of the Rothschilds' power can be scene in the 1974 mini-series Fall of Eagles.(F1) In the video, notice that the man in uniform is the Austrian Emperor, the other man is one of his administrators, and they are talking about what they must do to satisfy the Rothschilds. A simple banker was able to bully an Austrian emperor!
Video 1—A banker bullies an Austrian emperor
The bond market today is not dominated by the Rothschilds or any person or family. It has still retained its power, though, and can bully countries just like the Rothschilds once did. During the Great Recession of 2008-2012, European countries had to pass a number of austerity measures so that bondholders would loan them more money. When a country installs "austerity measures" it agrees to reduce its debt, usually through reductions in government spending but sometimes in higher taxes. Almost everything the European Union did to keep countries from going bankrupt was an attempt to placate the bond market. It seemed as if the bond market was the most powerful entity in Europe. Perhaps it was. It was for these reasons James Carville once made the following remark.
Quotation 3—Reincarnated as the bond market
I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody.
—Carville, James. Quoted in The Wall Street Journal on February 25,
1993. A1.
Bond are safe, but not riskless
The point of all this is to demonstrate that bonds are not without risk. The businesses and government agencies selling the bonds could go bankrupt, in which case they repay only a portion of what they agreed to pay. Perhaps more important to bondholders is unexpected inflation. Bonds are considered safe in that the issuer signs a legal contract agreeing to repay you an exact number of dollars (or some other currency). What the contract does not protect you against is being repaid dollars of a much, much lower value than the dollars you lent. Protect yourself by keeping some money in cash accounts and some money in stocks.
There are some bonds formally linked to inflation, which means they pay more dollar bills if inflation rises, thereby protecting you from unexpected inflation. Insurance always has a cost, and these bonds pay a lower average rate-of-return. Remember, anytime an investment becomes less risky it pays a lower average rate-of-return (the reverse is also true). A regular bond might pay you 3% interest while one linked to the inflation rate may only repay 2.8%. Is the risk worth the cost? That is what every investor asks, and the answer depends on their willingness to hold risk.
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(2) What Percent of My Income Should I Save For Retirement?
(3) Saving and Investing for Retirement
References
(E1) Richard J. Evans. 2005. The Coming of the Third Reich.
(F1) Fall of Eagles. A Requiem for the Crown Prince. 1974. TV Mini-Series. BBC: London, UK.
