Capital Invested Vs. Risk to Capital

We talked a little about investing and taking risk. With the “Big Hiccup” that happened in the stock market from May 3 to May 7, some people lost everything that they made “year to date.” Other people, like me lost very little ground for the week. It comes down to the type of investment strategy that you created for your portfolio. You may say that you have no investment strategy, you just buy what someone tells you or you just buy what sounds good. What you don’t realize is that you create an investment strategy whether you want to or not. The strategy created allows you to “benefit or not” in up markets and allows you to get “messed up,” accepting the risk in bad markets.

Ninety-five percent of my portfolio is in junk bonds. About 4% is in stock and “Closed End” Bond Mutual Funds, and about 1% is in cash. The 1% means that I am fully invested in something all the time. When new money comes into my account from interest or dividends, the money is reinvested back usually into other junk bonds. I purchase some stocks or sometimes but rarely “Closed End” Bond Mutual Funds. They also give dividends. These dividends are reinvested into Junk Bonds. This is how I maximize my profits over the years and minimize my risk to capital and inflation. Depending on how much risk I want to take, I may invest in Junk Bonds with less than 4 years maturity (little capital, inflation, interest rate, and market risk) or Junk Bonds with a maturity greater than 4 years (more capital, inflation, interest rate, and market risk). The further you go out on maturity, the more inflation, interest rate, capital, and market risk you take.

Bonds must be paid according to the bond indenture. If they don’t pay, the bond trustee will force the company into Chapter 11 bankruptcy. Since bonds get paid before stock in bankruptcy they are safer than stock.

Some people will buy 95% stock, stock or bond mutual funds, 4% or less individual bonds, and have very little cash. These people maximize their profit potential but also maximize their risk to capital. They do well in bull markets but get “killed” in bear markets. In mix markets they go no place with very little return for their risk taking.

So you think that having 95% in cash is a better idea than stocks or bonds? Here you will minimize profits but you will maximize risk due to inflation. If inflation is running 4% per year and you only receive 3% interest in CDs, high investment grade bonds, or in your bank account, you will lose 1% to inflation every year. If you would buy a “KFW Frankfurt/Main 1.125% of 02/24/2012” Corporate Bonds for $999.87, you would make 1.132% per year interest and get $1,000 on 02/24/2012. This bond is rated “AAA.” You can’t get any better than that. With inflation running at 2%, you would lose .875% in purchasing power per year.

I can remember working for $390 per month. With that, I bought a new car and a house with money left over. Today that will not pay my utilities or most people’s rent. This is what inflation will do to you. But you will minimize your risk to capital. Too bad, your capital will not buy much for you in the future. This is why you have to make your capital grow using investments for the long term.