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Chapter 10. Everything You Need to Know ... > The Basics of Investing - Pg. 101

Everything You Need to Know About Investing Your 401(k) Money 101 For What It's Worth Bonds are often referred to as fixed-income investments. They get the handle from the fact that the income you receive is fixed. If a $1,000 bond pays you 8 percent interest, you get $80 every year you own the bond. If interest rates go up or down; if the stock market goes up or down; if inflation goes up or down; if your bank account goes up or down--you get $80. What's fixed stays fixed. If you sell your bond before maturity, your bond goes to market (just like stocks) and investors bid on it. The amount of money they offer you is in direct proportion to the interest rate your bond is paying when compared to what interest new bonds are paying. Using our example above: Let's say you buy a bond, expecting to hold it until maturity, and then two years in you need your money back. When you go to sell your bond, you find that interest rates have gone up. New bonds are going for 10 percent. So it's not very likely anyone will want your lowly 8 percent bond. The only way you can get them to buy it is to discount the price: give the buyer a deal; put it on sale. Any way you look at it, you're about to lose money. Here's what happens when interest rates go up after you buy a bond: Step 1: Your Bond: $1,000 ÷ 8% for 8 years = New Bonds: $1,000 ÷ 10% for 8 years = Difference = Step 2: $1,000 ­ $160 = $840 $640 ­ $800 ­ $160 An investor would pay you about $840 for your $1,000 bond, a loss of 16 percent. And if interest rates go down: Step 1: Your Bond: $1,000 ÷ 8% for 8 years = New Bonds: $1,000 ÷ 6% for 8 years = Difference = Step 2: $1,000 + $160 = $1,160 $640 $480 $160 An investor would pay you about $1,160 for your $1,000 bond, a gain of 16 percent. Remember, bonds have a love-hate relationship with interest rates. As you can see from the above example, when interest rates go up, the bonds you own are worth less because an investor can get a higher interest rate on a new bond. The reverse is also true. When interest rates go down, the bond you own is worth more. When you buy bonds, you are making an interest rate bet. So on the day you buy your bond, shout loud and clear, "Hear ye! Hear ye! From this day forward, interest rates will go down!" If you hold your bond until maturity, you get your money back. However, when you get your $1,000 back 10 years from now, will it still be worth $1,000? Answer: No. Inflation will have eaten away at its buying power. The $1,000 in your pocket doesn't buy the same goods and services it did 10 years ago. In fact, at 4 percent average annual inflation, it's only worth about $676.