<i>The Ethical Investor</i>: Wall Street Ripoff #6 - Telling You That Bonds Are Safer Than Equities

As I said in my last post, when investing clients tell their stockbrokers that they want to minimize their risk to world events, brokers typically suggest that they increase their holdings of bonds and decrease their common stock holdings. In today's world, this is terribly misguided advice.

Bonds have the illusion of being less risky than stocks because bonds have a stated interest payment attached to them that must be paid by the issuer or they go into default. This seems to be a much more certain payment stream than stocks as shareholders only get a share of the firm's profits and there is no guarantee what these profits will be or when they will be paid out to shareholders in dividends. In addition, bonds are higher up in the capital structure than equities so if a firm gets in trouble, the bond holders are more likely to recoup a larger percentage of their investment than the equity investors below them.

This is all factually true. But, it ignores the elephant in the room. The great fear that all investors have, or should have, is how are their investments going to do if inflation comes roaring back. And the answer is, bonds do terribly with unexpected inflation.

That "certain" interest payment you thought you were getting on a bond becomes a lot more worthless in a world of high inflation. Imagine you have a bond that promises to pay you 4% a year for the next twenty years. And now, imagine if inflation comes screaming back to say 8% per year meaning that all prices of all goods, on average, start increasing every year at 8%. Suddenly, that 4% yield you are getting on your bond doesn't look so good. Yes, you still receive the 4% return each year, but it costs 8% more to live each year so you are losing 4% of your purchasing power or real wealth every year.

And it doesn't make any difference whether you hold corporate bonds, muni-bonds or US Treasury bonds. If you have long maturity bonds, say twenty year lives, with 4% annual coupons attached and 8% inflation comes back, they are going to be worth about half as much in the market immediately. You will have lost half your net worth if you were fully invested in bonds.

You might argue that you are indifferent to the market price of the bonds you hold because you don't intend to sell them prior to maturity. But, that doesn't help you avoid the loss. At maturity, you will get your $1,000 back and you will have received your coupon payments, but they will only buy half as much stuff compared to what $1,000 buys today due to the higher prices inherent with inflation. Your purchasing power, and thus your wealth, would have been decimated.

There is no guarantee that equities will do well either in such a high inflationary environment, but it is hard to imagine that they will lose half their real value. Remember, when you buy a share of stock you are buying a piece of a company and the company is composed of hard assets like factories, warehouses and inventory that should all appreciate close to the rate of general inflation. Historically, equities have not done well with spikes in inflation, but that is because the economy and growth suffer with high inflation. Since we are already suffering from a low growth, never ending global recession, much of this downside is already baked into the equity prices you pay in today's market. You may not see that if you think the equity markets are trading near all time highs, but they really aren't once you adjust them for inflation, both historical and expected, as I discuss in this previous Huffington Post article.

I know what you are thinking. You're probably saying, how do I know that inflation is coming back? We are in the middle of a global recession and it certainly appears that demand for products and prices are decreasing. Doesn't deflation seem more likely in this environment than inflation. It turns out that you don't need a strong booming economy to have runaway inflation. Rather, it is in very weak economies like Zimbabwe recently or in the Weimar Republic in Germany after the WWI that inflation really exploded.

To give you a full response to why I believe inflation is coming takes more time, which is why I wrote my new book, Survival Investing. But, the basic argument is as follows.

• The US doesn't seem close to getting its spending under control.
• There doesn't seem to be any groundswell by either party to dramatically increase taxes in the near term.
• Growth is anemic worldwide.
• The country is currently running a trillion dollar plus deficit.
• The imbalances in Social Security and Medicare will add another trillion to this annual deficit just over the next ten to twelve years.
• Where is the US going to get the money to pay these deficits? They can't keep borrowing the deficit each year as their debt to GDP now exceeds 100% if you include the debt that the Social Security trust holds as that has been spoken for.
• The answer, the US is not going to default. So what is left? They are going to print money, lots of it. If they print just500 billion a year to try to fund half of the deficit (Bernanke recently announced he will print40 billion a month for the foreseeable future which works out to500 billion a year) , this means the amount of currency and reserves which is currently3 trillion will increase 16% a year. 16% more money out there each year, same amount of stuff, tells me prices have to go up dramatically, measured in dollars.
• Finally, unlike other countries like Switzerland, Japan and Norway, the US doesn't seem to have any aversion to counterfeiting its own currency in order to pay its government's bills, so I can't see any groundswell of public opinion shutting the Fed's counterfeiting operation down any time soon.

So, watch out when your broker tells you that bonds are a safer investment than stocks.

20 Ways Wall Street is Ripping Off Small Investors:

1. Providing nominal returns, not real returns.
2. Encouraging too much diversification, if that's possible.
3. Hiding fees and expenses.
4. Turning you into a passive investor.
5. Convincing you that money markets are the same as cash.
6. Telling you that bonds are safer than equities.
7. Explaining that in the long run equities outperform bonds.
8. Simply by lying about their products.
9. Convincing you that their bank is a large, stable, safe operation to deal with.
10. Recommending products that have enormous sales commissions attached to them.
11. Cheating you on bid/ask spreads.
12. Selling you what they don't want.
13. Measuring your success in dollars.
14. Lending your securities to others.
15. Ripping your eyes out if you ever try to close your account.
16. Grabbing any slight positive real return for themselves.
17. Sticking toxic waste to small investors.
18. Pretending they can pick stocks.
19. Acting like they are your best friend and they have your best interests at heart.
20. Knowing next to nothing about the value of holding real assets like gold and real estate.

John R. Talbott is a bestselling author and financial consultant to families whose books predicted the housing crash, the banking crisis and the global economic collapse. You can read more about his books, the accuracy of his predictions and his financial consulting activities at www.stopthelying.com

Content concerning financial matters, trading or investments is for informational purposes only and should not be relied upon in making financial, trading or investment decisions.