Bonds are a security and are generally good investments for the older crowd who wants to earn higher interest rates for income. Bonds also belong in younger portfolios to enhance investment balance. But beware; the Big Bad Wolf may be knocking on the bond investing door.

In 2009 you couldn’t make 1% a year in the safest investments with easy access to your money. Examples include: money market bank accounts, short-term CDs, T-bills, savings accounts, and money market funds. But you could earn more than 6% in some bonds and over 4% in the safest ones in the world, the U.S. Treasury bond. Why not jump on these good investments?…

The answer is that bond investing carries risk… more than the average new investor thinks. First, there is credit risk. The issuer of the security could get into financial trouble and fail to make timely payments of interest as promised. Even worse they could go broke. This risk can be greatly reduced by putting your money into a bond fund vs. an individual issue.

Interest rate risk is another animal altogether, and with interest rates at all-time lows the wolf is huffing and puffing at the door of bond investing. Unfortunately, the new investor is likely unaware of his presence and does not sense the danger. In a few minutes, you’ll get the picture.

When you buy a bond you are lending the issuer (like a corporation) money for a promise that reads something like this. “Lend me $1000 and in return I’ll pay you 5% a year in interest. In the year 2035 I’ll pay you back your $1000.” After the issue is originally sold to an investor, it then trades in the secondary market. The good news is that the bond can then be bought and/or sold any time between issue and 2035.

The scary news is that the price or value of the security changes as it trades in the market. When interest rates are falling these fixed-interest-rate investments go up in value. When interest rates go up, interest rate risk can bite you in the posterior… because bond prices (values) go down.

That’s how bond investing works. Picture owning the 5% security we used as an example. As long as the issuer remains financially strong and interest rates remain stable, your investment should be worth about $1000. What would happen if rates in the economy headed toward 10% for similar bonds being issued? Remember, your 5% rate is locked in until 2035.

Only a fool would offer you $1000 for a security that pays $50 a year when any investor could get closer to $100 in yearly income in the open market. There are plenty of fools out there, but no one is that dense. Your investment is headed toward a ½-off sale.

Bonds can be very good investments when interest rates are falling. They are not good investments when rates are on the rise. It doesn’t matter if you are rich or poor, young or old, new investor or experienced. The wolf is knocking on the bond investing door, and sooner or later interest rates will go up. Don’t let interest rate risk take a big bite out of your investment portfolio. Don’t chase bonds just to earn higher interest rates.

1) Racking Up Junk Debt: Credit card offers are ubiquitous in American society. They’re easy to use because most stores accept plastic, so a lot of people have ended up racking up debt. According to the Survey of Consumer finances in 2007 something like 44% of American households carry a balance on their plastic. This is a problem as credit card debt can be very expensive, with some cards charging upwards of 20%. Solution to this? Get a debit card.

2) Not investing soon enough: Its trite and tired advice, but its true. The more time you have to invest, the more money you can generally make. Time is important for two reasons. First, if you have more time, you can recover from mistakes before retirement. Second, if you have more time you can take advantage of compounding to build wealth. A good way to do this is by purchasing stock in a company with a moderately high dividend payout and good long term business prospects in a boring established industry – utility stocks are good for this. Then just sit back and let the dividends compound.

3) Investing in assets that are too risky:  The idea behind this is that long term cash is more likely to grow rapidly when invested in stocks or directly in small businesses. It’s important that you take this advice with a grain of salt. Last years stock market declines and the nations deep recession have obliterated billions of dollars of US wealth. In addition, this principle is based on the historical performance of US equity markets and tends to ignore historical trends internationally. So, there is no guarantee that riskier assets will yield a higher return, they just tend do do so. Consider instead a mix of safe and risky assets, you’ll have the best of both worlds.

4) Under or overdiversifying: Conventional wisdom suggests that if you spread your money around, you’ll be better off. This economic principle is based on the doctoral dissertation of a guy called Harry Markowitz back in the 1950s. Markowtiz’s theory and ideas were adopted and were subsequently refined into modern portfolio theory by later economists. Its currently become fetishized and is a main pillar of wall street dogma.

Iconoclasts like David Kiyosaki argue that diversification is essentially a class based idea. They say that diversification is basically for middle class investors who don’t have the resources, time or inclination to develop a business or speculate intelligently. In this case, the numbers back up thinkers like Kiyosaki. Really wealthy people tend to have concentrated stock or business holdings. However, for most people its probably better not to put all your eggs in one basket, its just that if you want to get really rich. you need to think critically about this.

5) Investing in what you don’t understand: The world is growing exponentially more complex. Thus, its often hard to evaluate the amount of risk associated with some kinds of investments. For example, the recent stock market downturn was driven by heavy bets on derivatives. The only problem was that these products were too new for banks to reliably calculate the risks associated with owning them. The end result of this – as everyone knows – was epic losses with attendant titanic social and political repercussions. Another example is the stock market boom back in 2001. Small investors crowded into internet stocks at inflated prices, when in fact most of these investors had no way of accurately judging what the underling prospects of those business were. The outcome of boom of 2001 is also well known and bears no repeating here.

6) Relying on the advice of others: Classical sociological theory argues that information and advice are transmitted via social networks. That is, most people make decisions based on what members of their social networks are doing. For example, they buy stocks because the guy in the cubicle next door bought some. Or they buy a product because their mom or sister in law thought it was a good idea. This is dumb. You’ll only go as far as your peers if you follow this pattern. Instead, it makes sense to model your behavior on the advice of people who have demonstrated extraordinary success in achieving financial security. Also, its preferable that the person you model your behavior on be dead – live gurus are unreliable because their future track record is unknown. For example, Suze Orman is good, but she could give bad advice, get sued, become corrupt, etc etc. Model your behavior on rich dead people, not your friends.

By James Hendrickson

James Hendrickson comanages Dual Income No Kids with his wife Miel. Dual Income No Kids is a personal finance blog by and for couples interested in personal finance.