How Government Bonds work, with fictional friend Barry

Meet Barry: he's a few decades older than Quentin, so instead of focusing on stocks as the overwhelming majority of his portfolio, his portfolio manager tells him he should consider moving to a more balanced portfolio composition that includes both stocks and bonds. 

Stocks are tiny pieces of a company-- big companies, like Apple, Google, Microsoft, and so on divide their worth up into billions of tiny pieces, and when you buy "1 share of Apple," for instance, you're buying a single one of those billions of tiny pieces of one of the biggest companies in the world (actually, as of press time, the biggest company in the world). 

When the company does well-- publicly traded companies have to report from time to time to their investors how well they did since their last report-- or launches a new, promising product, the value of the stock rises. When the economy isn't doing so well, people aren't using the company's service or buying its product, so its revenue falls, and investors don't feel as good about the company, so the stock price falls.

In investment, one of the fundamental principles is that the more you're willing to risk, the bigger the potential reward you'll end up making.

As far as stocks go, Apple, our example, is a pretty safe one, for a number of reasons, among them: everyone needs a cell phone, and most cell phones are iPhones, people like having the latest and greatest tech, so they buy new versions of things they already have when they come out, and the products are genuinely great products, so investors trust the business to do well in the future given it has a long history of doing well in the past. 

But here's a chart of the change in Apple's stock price throughout each year, going from 2010 to 2022. 

	Start ($)	End ($)	Change
2010	7.62	11.52	51.18%
2011	11.63	14.46	24.33%
2012	14.62	19.01	30.03%
2013	19.78	20.04	1.31%
2014	19.85	27.59	38.99%
2015	27.85	26.32	-5.49%
2016	25.65	28.95	12.87%
2017	28.95	42.31	46.15%
2018	43.13	39.44	-8.56%
2019	38.72	73.41	89.59%
2020	74.06	132.69	79.17%
2021	133.52	177.57	32.99%
2022	177.83	129.93	-26.94%

 Overall, if Barry had invested $1,000 in Apple in early January 2010, by late December 2022, he would have accumulated more than $16,000 but that seems less awesome, in comparison to the fact that he could have been all the way up well past $22,000 at one point. 

Over this period, Apple has averaged a return of 24% every year, and since it was founded, about 18%. Such strong, sustained, sustainable, growth makes Apple one of the best stocks to invest in, in general, and one of the most powerful forces in the broader market, for reasons to be explained in a later post, which I'll link to in this one when it goes live.

But let's say that Barry is close to retiring, and gaining 46% then losing almost 9%, then gaining more than 89%, then gaining 79%, then gaining almost 33%, then losing almost 27%, feels too much like a big, scary rollercoaster that Barry doesn't want to ride, so Barry agrees with his portfolio manager that he needs a safer option.

The safer option Barry's portfolio manager probably suggested should take up a bigger percentage of a more conservative portfolio for Barry is a government bond.

Bonds put out by the US Treasury are some of the most trusted, safest investments that exist because the world is so confident that the dollar has value now, the dollar will have value in the future, and, despite political shenanigans around things like the debt limit, the Treasury will pay out the bonds it sells to investors when the time comes.

So let's say, then, that, instead of buying $1,000 worth of Apple stock, Barry buys $1,000 in US Treasury 10-year bonds. 

You can think of a bond, essentially, as a loan you're making to the government for a certain amount of time, signing a contract when you buy in to get your initial investment, plus a certain amount of interest fixed at the rate when you bought the bond. You won't see the money, really, until the fixed term of the contract is up. 

In Barry's case, he wants a 10-year bond, so he basically signed a contract with the government, that, right now, means, "I'll give you $1,000 now, and you give me back my $1000, plus 4.03% interest every year, all in one lump sum, 10 years from now"

So Barry's returns look like this:

	Start	End	Rate
2023	$     1,000.00	$ 1,040.30	4.03%
2024	$     1,040.30	$ 1,082.22	4.03%
2025	$     1,082.22	$ 1,125.84	4.03%
2026	$     1,125.84	$ 1,171.21	4.03%
2027	$     1,171.21	$ 1,218.41	4.03%
2028	$     1,218.41	$ 1,267.51	4.03%
2029	$     1,267.51	$ 1,318.59	4.03%
2030	$     1,318.59	$ 1,371.73	4.03%
2031	$     1,371.73	$ 1,427.01	4.03%
2032	$     1,427.01	$ 1,484.52	4.03%
2033	$     1,484.52	$ 1,544.35	4.03%

Barry made an initial investment in Apple in early 2010, and by the end of 2022, had increased his money 16, almost 17 times. But there was a lot more risk inherent in the investment that generated those much bigger returns; remember, go back to the previous table, and you'll see how in some years, it wasn't just that the price of the stock rose less than expected, it actually fell, from the beginning to the end of the given year. 

Treasury Bonds, in general, carry less risk than stocks for 2 reasons:

1. Who is behind them: Investors are more likely to trust the Treasury to give them their returns than they are Apple, as trustworthy as Apple might be
2. You know what your returns will be: You're guaranteed the return of that bond will be a certain rate when you buy it (4.03% per year, and 54% overall, in our example), but that rate is much lower than the average rate you could get from a stock (a maximum of an 89% return in one year on the Apple table, but a total return of more than 1500%)

Most investment professionals (let me remind you again, I am not one of them) will say that, as you get older, your portfolio should include a bigger proportion of bonds and a smaller proportion of stocks because of a concept called the time horizon, which I'll illustrate in another post, linked here when it goes live. Put simply, the younger you are, the more time you have for your investments to recover from a bad year, and the more time you're giving yourself to reap the fruits of a good year. 

So back to Barry: he gave the Government $1,000, and the government gave him the bond. At the end of the 10-year term of the contract for the bond, the Government gave Barry back his $1,000, plus the interest he earned, so Barry actually got back $1,544.35.

This is the trade-off between risk and reward, and the trade-off between investing in stocks or bonds. (You can, and most investors do, invest in some mix of both.)