Stock Market

Bonds are definitely safer than stocks ... unless you are in a period of high inflation, that is. When the cost of living is going up rapidly, an all-bond portfolio carries a wipeout risk that makes the gyrations of the stock market look mild.

In 1971, for example, the year-end yield on long-term government bonds was just below 6 percent. Say you invested your entire net worth$100,000in these fixed-income securities at that time in order to generate current income. That year, inflation was running at 3.36 percent making your real return 2.64 percent.

By the end of the decade, nearly 60 percent of the real purchasing power of your initial investment had been obliterated! To add insult to injury, the $6,000 you received in interest income each year now only buys you the equivalent of $2,409 worth of goods and services. Although your portfolio still has $100,000 worth of bonds paying you $6,000 per annum, the true economic net worth would be less than it was when you began investing; a terrific tragedy.

Instead you'd much rather own shares of outstanding corporations. Why? A good enterprise is capable of passing on cost increases to the customer in the form of a higher selling price without affecting sales. Likewise, because it is not capital intensive, it doesn't have to worry about replacing huge factories that now cost more. The net result is that inflation inflicts far less damage. The moral: an all-bond portfolio can actually be riskier than an all-stock portfolio in real, honest-to-goodness economic terms during periods of high inflation.

Bond Ratings

Bonds are rated by rating agencies such as Moody's and Standard and Poor's. Fixed income analysts pour over financial data provided by the issuers of bonds and assign grades to help investors determine the level of risk a bond issue posses. The higher the credit quality, and thus rating, the lower the yield. The reason is simple: Companies that are high-risk have to offer higher interest payments to compensate for the greater probability of default.

As an individual investor, you should relegate your purchases to the upper levels of investment grade securities. Otherwise, you might find yourself in the unhappy of position of losing your entire investment.