Living with fluctuations
Why even safe bonds swing in price, the shareholder's two positions, and Zweig's list of what you can control.
FinanceGraham ch. 8About 5 min: 3 reading, 2 practiceUpdated
General education, not financial advice.
- Explain why a long-term bond's price falls when interest rates rise
- Describe the shareholder's double position as part-owner and as holder of a tradable share
- List what an investor can and cannot control
The Intelligent Investor: Benjamin Graham's ideas: lesson 9 of 24
- Graham ch. 1
- Investment versus speculation 4 min
- Graham ch. 2
- Inflation and the investor 4 min
- Graham ch. 3
- A century of market history 5 min
- Graham ch. 4
- The defensive investor's portfolio 4 min
- Graham ch. 5
- Defensive investors and stocks 4 min
- Graham ch. 6
- What the enterprising investor avoids 4 min
- Graham ch. 7
- What the enterprising investor does 5 min
- Graham ch. 8
- Mr. Market 5 min
- Living with fluctuations 5 min
- Graham ch. 9
- Investing in funds 5 min
- Graham ch. 10
- The investor and his advisers 4 min
- Graham ch. 11
- Security analysis for the lay investor 4 min
- Graham ch. 12
- Per-share earnings and their traps 4 min
- Graham ch. 13
- Comparing four companies 4 min
- Graham ch. 14
- The defensive investor's screen 4 min
- Graham ch. 15
- The enterprising investor's screen 7 min
- Graham ch. 16
- Convertibles and warrants 6 min
- Graham ch. 17
- Four extreme case histories 7 min
- Graham ch. 18
- Eight pairs of companies 7 min
- Graham ch. 19
- Shareholders, managements and dividends 5 min
- Graham ch. 20
- Margin of safety (1): the idea 5 min
- Margin of safety (2): in practice 7 min
- Graham appendix 1
- The superinvestors of Graham-and-Doddsville 6 min
- Graham postscript
- Graham today 7 min
Try first
You haven't learned this yet, so guess. Guessing before you read helps the explanation stick. Nothing here is scored.
Pairs with Graham, The Intelligent Investor, revised edition with commentary by Jason Zweig (HarperBusiness, 2003), chapter 8, "The Investor and Market Fluctuations" (second part)
What it is
Bonds swing too. Graham warns that even a bond whose interest and repayment are perfectly safe can change a lot in price when interest rates change. When rates rise, older bonds paying less interest become less attractive, so their price falls; the longer the bond's life, the bigger the fall.
Two positions. A shareholder is, at once, a part-owner of a business (whose value depends on its profits and assets) and the holder of a piece of paper that can be sold in minutes at whatever price the market offers. You can use whichever position suits you, which is a privilege, not an obligation.
Graham's warning: an investor who is "stampeded or unduly worried" by unjustified market falls is "perversely transforming his basic advantage into a basic disadvantage". The advantage is the freedom to ignore the price: the true investor is rarely forced to sell.
Quick check
Tap an answer to check it.
Interest rates rise. What happens to the market price of an existing long-term bond?
- Its fixed interest now looks less attractive than new bonds
- Safety of payment doesn't fix the market price
Show answer
It falls. Higher rates make older, lower-interest bonds worth less.
Why it matters
Everyone who owns stocks will see their value fall sharply at times. Knowing in advance that this is normal, and that it is a price, not a loss you must take, is what lets a long-term investor keep going.
Zweig adds a list of what you can control, whatever Mr. Market does:
- your costs, by trading rarely and avoiding expensive funds;
- your expectations, by being realistic about returns;
- your risk, by deciding how much to put in stocks, diversifying and rebalancing;
- your tax bills, by holding for longer;
- and, most of all, your own behaviour.
Worked example
A bond pays 5 a year on a face value of 100 with 20 years left, and was priced at 100 when new bonds also paid 5%. Now new bonds pay 7% (payments once a year, for simplicity).
Its price falls to the amount that gives a new buyer 7% a year: the present value of 5 a year for 20 years plus 100 at the end, at 7%, about 78.81. That's a fall of about 21%, though the borrower is just as safe as before.
A similar bond with only 2 years left would fall only to about 96.38: short bonds swing much less.
(Graham reports that between 1964 and 1970, rising rates cut the price of first-grade bonds of about 20 years by as much as about 38%.)
Common mistake
Treating a fall in price as a loss you have to act on. Unless you need to sell, a lower price changes what Mr. Market offers. If the business or the borrower hasn't deteriorated, it doesn't change what you're paid; Graham says to check that first.
Key terms
- interest-rate risk
- the chance that rising rates lower a bond's market price
- maturity
- when a bond is repaid; longer maturity means bigger price swings
- present value
- what future payments are worth today at a given rate
- behaviour
- the control Zweig stresses "most of all"
Practise the key terms
Tap a card to turn it over. 4 cards.
| Front | Back |
|---|---|
| interest-rate risk | the chance that rising rates lower a bond's market price |
| maturity | when a bond is repaid; longer maturity means bigger price swings |
| present value | what future payments are worth today at a given rate |
| behaviour | the control Zweig stresses "most of all" |
Practice
Sort it
Within your control, or not?
What the market does next month
Mr. Market's mood.Show answer
You can't control it. Mr. Market's mood.
How often you trade
Costs are in your hands.Show answer
You can control it. Costs are in your hands.
How much of your money is in stocks
Your risk level.Show answer
You can control it. Your risk level.
Whether interest rates rise
Set by markets and central banks.Show answer
You can't control it. Set by markets and central banks.
Whether you panic-sell in a fall
Your behaviour.Show answer
You can control it. Your behaviour.
Quick quiz
Tap an answer to check it.
Why does a 2-year bond lose less than a 20-year bond when rates rise?
- The borrower can be the same
Show answer
Its lower interest is only locked in for 2 years before you get your 100 back. The shorter the time to repayment, the smaller the effect.
In short
- Even safe bonds change price when interest rates change; longer bonds change more.
- A shareholder is both a part-owner and the holder of a tradable share.
- Graham: being stampeded by falls turns your advantage into a disadvantage.
- Zweig: control your costs, expectations, risk, taxes and above all your behaviour.
Mastery check
Answer without looking back. Score 80% or more and the lesson is marked done. Your result is kept only in this browser.
Check yourself
Answer in your head first, then open the answer. Nothing is saved.
What is the shareholder's "basic advantage", in Graham's sense?
Show answer
The freedom to decide whether or not to act on the market's price, including not selling.
Rates rise from 5% to 7%. Which loses more value: a 2-year or a 20-year bond paying 5%?
Show answer
The 20-year bond (about 78.81 against 96.38 in the lesson's example).
Name three things Zweig says you can control.
Show answer
Any three of: costs, expectations, risk, taxes, and your own behaviour.
Further reading
- Benjamin Graham, The Intelligent Investor, revised edition with commentary by Jason Zweig (HarperBusiness, 2003), chapter 8.
- On this site: Present value and Bonds and money-market funds.
Finished? Mark it done to fill in your leaf on the Finance map.