Sunday, August 2, 2009

Nowhere to go! That’s the problem facing investors. Everyone knows you’re supposed to be diversified — some stocks, some bonds and some money-market funds. Right now, nothing seems terrifically good.

First, there’s the stock market. It has had ups and downs since the beginning of the year. The averages now are near where they were on Jan. 1. Everyone still remembers the huge drop of last year. The past month hasn’t helped, either. Stock investors are sitting on paper losses, which might be the best thing you can do with them. If history repeats itself, stocks would be expected to go up, eventually. Their long-term average growth had been about 10 percent until last year.

From an investor’s point of view, the best stock rise is a rise in a depressed stock you already own. Until the price goes back up to the price where you bought it, all the gain in value is tax-free. You don’t have to pay capital-gains tax until you sell it at a price higher than what you paid. On the other hand, if you sell stocks and take net capital losses, you can only subtract the first $3,000 from this year’s income in figuring your income tax. You have to carry forward the rest of the loss to next year’s income tax. With these choices, many investors stand pat and hope their stocks will go back up.

Then there are bonds. U.S. Treasury bonds are safe, but right now they have historically low yields. A 10-year Treasury bond now has a yield of about 3.6 percent. What if interest rates are up a year from now, with Treasury bonds issued then having a yield of 5 percent? What does that do to the value of a $1,000 Treasury bond with a coupon rate of 3.6 percent that still has nine years to go until maturity? If you wanted to sell it then, you would get just $897 because that price would give the new buyer a 5 percent yield to maturity. This drop in value is what bond buyers worry about in an atmosphere of rising interest rates. This is what happened in the 1970s as interest rates rose.

If you are buying corporate bonds instead of Treasury bonds, you not only have to worry about interest rate rises, you also have to worry about default. Ask the people who had Chrysler bonds or General Motors Corp. bonds. Because of the default risk, investment-grade corporate bonds now yield an average of 5.75 percent. High-yield bonds with a much greater risk of default can yield 12 percent or more. Those with a tolerance for risk also can invest in stocks, real estate or their own businesses. Others who look at recent history will stand pat.

In the current unsettled atmosphere, the ultimate stand-pat position is in money-market funds. They are yielding only about 1.25 percent now, but their yield will increase if interest rates go up. Under uncertain government policies and threats of higher taxes, many investors will not be in the mood to take risks, and they will stand pat.

Robert L. Hershey is a consulting engineer and author of “All the Math You Need to Get Rich,” Open Court Publishing Co., 2002.

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