Bonds, Hedge Funds, and Building a Portfolio - Behavioral Finance Chapter 12 Part 2
Part 1 covered stocks and the basics of asset classes. Now in the second half of Chapter 12 of Behavioral Finance and Investor Types, Michael Pompian walks through the rest of the investment universe: bonds, hedge funds, real assets, and finally how to put them all together into a portfolio.
Bonds: The Basics
Bonds are loans you make to somebody. A government, a corporation, a city. They promise to pay you back on a specific date (the maturity) and pay you interest along the way. That’s the short version.
Pompian goes through the key things you need to know about any bond: maturity, credit quality, interest rate, price, and tax treatment.
Maturity is when you get your money back. Short-term is up to 5 years. Intermediate is 5 to 12. Long-term is 12 and beyond. The longer the maturity, the more the price bounces around when interest rates move.
Credit quality is how likely the borrower is to actually pay you back. Rating agencies like Moody’s, S&P, and Fitch grade bonds from AAA (very safe) down to junk status (BB and below). Junk bonds pay more interest because there’s real risk the borrower defaults. But here’s the thing: Pompian notes that junk bonds can absolutely be worth buying when the spread (the extra interest over Treasuries) gets wide enough.
Price and interest rates move in opposite directions. When rates go up, existing bond prices go down. This confuses people, even professionals. The yield curve shows this relationship across different maturities. When short-term rates are higher than long-term rates (an inverted yield curve), it often signals a recession is coming.
The Bond Menu
Pompian runs through the main types of bonds:
- U.S. Treasuries are the safest. Backed by the government. Even after S&P’s 2011 downgrade from AAA to AA+, the government can always print money to pay you back. Whether those dollars are worth as much is another question.
- Mortgage-backed securities are pools of home loans packaged into bonds. The big risk? When rates drop, homeowners refinance, and your principal comes back early at the worst possible time.
- Corporate bonds pay more than Treasuries because you’re also taking on the credit risk of a specific company.
- High-yield (junk) bonds pay even more but carry real default risk.
- Global bonds let managers play both interest rate differences and currency movements across countries.
- Municipal bonds are issued by state and local governments and are usually tax-free. Great for high-tax-bracket investors, but not always. It depends on your specific tax situation.
- TIPS (Treasury Inflation-Protected Securities) adjust for inflation. Good idea, but you get taxed on the inflation adjustment even before you receive it, so hold these in tax-deferred accounts.
Hedge Funds: Proceed With Extreme Caution
Pompian is pretty blunt here. Unless you have a very well qualified team picking hedge funds and building a portfolio of them, you probably should not be investing in hedge funds. He says even the top 10 percent may not be good enough.
What makes hedge funds different from mutual funds? Less regulation, higher fees, less transparency, limited liquidity, and they use tools like short selling, leverage, and derivatives that regular funds don’t.
The fee structure is the classic “2 and 20.” That’s 2 percent of your money every year just for showing up, plus 20 percent of any profits. Some charge even more. The supposed justification is that hedge funds produce alpha (returns above the market). But here’s the problem: with those fees, the manager has every incentive to take big risks with your money. High-water marks and hurdle rates help a little, but not enough.
Then there’s the lock-up period. You can’t pull your money out for one to three years. And even after that, you can only redeem on specific dates. Transparency is minimal. The manager doesn’t want you (or competitors) to know what they’re doing. Trust is everything, and with limited regulation, fraud is a real possibility.
Real Assets: Stuff You Can Touch
Real assets are tangible things. Real estate, commodities, oil and gas, timber, even art and coins. The big selling point is inflation protection. When prices rise, the value of physical stuff tends to rise too.
Real estate works as an inflation hedge because landlords can raise rents. But only if supply and demand are balanced. If vacancy rates are above 10 percent, good luck raising rents on anyone. For serious investors, Pompian recommends private real estate partnerships with vintage year diversification. While waiting for those to get fully invested, REITs can fill the gap.
Commodities include energy, metals, agriculture, and soft commodities like coffee and sugar. You can get exposure four ways: buy the physical stuff (storage is a pain), use futures markets (complicated), invest through mutual funds (simplest for most people), or use exchange-traded notes.
Art and coins can store value, but they’re illiquid and prices depend on taste, condition, and collector behavior. Not exactly predictable.
Putting It All Together: Simple Portfolio Construction
This is where Pompian ties everything from the chapter into something practical. Portfolio construction is about combining assets so they work well together across different market conditions.
The math isn’t complicated for expected return. It’s just the weighted average of each asset’s expected return. If you put 60% in stocks and 40% in bonds, your expected return is 60% of the stock return plus 40% of the bond return.
Risk (standard deviation) is trickier. It depends not just on how volatile each asset is, but on how they move relative to each other. That’s correlation. If stocks and bonds don’t move together perfectly, combining them actually reduces your overall risk. That’s the whole point of diversification.
Pompian shows three sample portfolios using stocks, bonds, and cash. To compare them, he introduces the Sharpe Ratio: return minus the risk-free rate, divided by standard deviation. Higher is better. It tells you how much return you’re getting per unit of risk you’re taking.
The Bottom Line
This chapter was a crash course in what you can invest in and why mixing assets together matters. Bonds give you income and stability. Hedge funds are mostly for the ultra-sophisticated (and even then, maybe not). Real assets protect against inflation. And portfolio construction is the art of combining all of this so the whole is better than the parts.
Next chapter gets into the specifics of asset allocation, where Pompian starts customizing portfolios for individual investors. That’s where the behavioral finance angle really comes back into play.