Donald P. Gould

A very good question! And the answer is not so simple to explain.

But to make it simpler, start first with the example of a 10-year zero-coupon Treasury bond—a bond that pays no interest, but simply pays back $1,000 at maturity. If the prevailing interest rate on similar assets having a 10-year duration is 3%, then you would pay $744 for a new 10-year zero-coupon bond. Why? Because a bond bought at $744 today that matures at $1,000 in 10 years would pay you a 3% compound annual rate of return over those 10 years. Note that the price rises over time (from $744 today to $1,000 in 10 years), just as stock prices do, and it rises without any underestimation of future cash flows. (You estimated a $1,000 cash flow in year 10 and that’s exactly what you got.)

Now consider a stock. For simplicity, let’s take a stock that pays no dividends, similar to the zero-coupon bond that pays no interest. (This means that all profits are kept inside the company and reinvested in one form or another. Adding dividends to the example wouldn’t change the analysis much.) Let’s assume the stock’s systematic risk (its exposure to market-wide fluctuation) is average. (We would say this stock has a beta of 1.) We might estimate that the market expects about an 8% annual return on this stock. The stock’s 8% is higher than the T-bond’s 3% because the stock carries a lot more risk. Investors want to be compensated for taking on greater risk.

You would expect the stock’s price today to be set at a level such that if your estimations of future cash flow come to pass, the price will rise at 8% per year, on average. So, just as the zero-coupon bond price must be set today at a price lower than its price at maturity, the price of our stock today is also set at a level that will result in its price rising over time if one’s estimates of future cash flow actually come to pass. Note that you do not need to underestimate anything in order for the price to rise. If, in fact, you did underestimate future cash flows, then the price would rise faster than the 8% rate you originally expected.

Another way to think about it is this. The present value of the stock is the sum of the future cash flows, each discounted by the expected rate of return (8%). If you reverse the calculation and instead calculate future value, it will be today’s stock price compounded  forward at 8% per year (and therefore increased). For any positive expected rate of return, present value (today’s stock price) must be less than future value (future stock price).

Bottom line: the present value calculation has built into it the assumption that the stock’s price will rise over time.

First, let's understand what a dividend is. When a corporation makes a profit, it pays income tax on that profit, similar to the way individuals pay income tax on their wages and other income.What's left after the corporation pays income tax is known as "profit after tax" (PAT). A corporation with PAT can do two things with their PAT: (1) It can retain it in the business and either hold it as a reserve or invest it in new plant, equipment, R&D, etc.; and/or (2) It can distribute it to its shareholders. Such distributions are called "dividends." (Note: corporations with a history of profitability may choose to pay dividends even when the company is temporarily not earning profits.)

Apple Inc. earns huge PAT. The company has about 5.39 billion shares outstanding and currently pays $2.28 per share, per year in dividends to its shareholders. That amounts to about $12.3 billion in annual dividends paid, or roughly one-quarter of its PAT. If you are a shareholder of, say, 100 shares of Apple (symbol: AAPL), you receive $228 in dividends a year. You must report those dividends as income on your tax return. Depending on your tax bracket, you may pay tax on the dividends of as much as 20% of the $228, as well as state income tax, if applicable.

Because Apple paid tax on its profits, and then you paid tax on the dividends, some refer to this as double taxation of dividends. In fact, it is double taxation of corporate profits; the dividend itself is only taxed once. In order to avoid double taxation, some companies (for example, Berkshire Hathaway) choose not to pay a dividend. But many investors desire the steady income that dividends can provide.

This question looks simple, but really requires a lot of thought.

Let’s start with a few unpleasant facts.

1. You never know, at any point in time, if you are in a bear market. A bear market—commonly defined as a period in which a given stock index has dropped at least 20% from a peak—can only be identified after the fact. Until the market has dropped 20% from a peak, you are not yet in a bear market. Once it’s dropped 20%, you can say that you were in a bear market, but you still have no idea where the market’s going next of if you are in what will later be viewed as a bear market. Every uptick is potentially the end of a bear market and the beginning of a new bull market.
2. Consequently, advice about what to do during a bear market is really a fantasy that can only be enjoyed with the benefit of hindsight. Unfortunately, we can’t invest with hindsight. I’m fond of saying, if I ever knew where the market was going next, I wouldn’t have to provide investment advice for a living.
3. If stock prices have recently fallen by 20% (or any amount), that information contains absolutely zero predictive value of where they are going next, which of course is what really matters.
4. Falling stock prices do not, in themselves, tell you anything about how money is moving between, say, stocks and bonds. It is not necessary for even a single share of stock to be bought/sold in order for a stock’s price to fall. The lower price simply means that the equilibrium price (the price at which buyers and sellers are willing to transact) has changed. This happens all the time when a company halts trading in its stock and then makes a major announcement. If the announcement is good news, the price adjusts upward without any trades in the stock having taken place.

It is a false premise that you can know when you’re in a bear market. Market observers are fond of looking at a downward sloping historical stock index chart and saying “the market is going down” or “we are in a bear market.” The truth is, the only thing you can say with certainty is that the market has gone down and perhaps we were in a bear market. Where it is going next or whether we are in a bear market is anyone’s guess.

There is also a false idea, often promoted by the financial press, that when stock prices are falling, investors are “fleeing” stocks. This is patently absurd. For every seller, there is a buyer. The number of shares owned does not change, only the identities of the owners.

So, to get back to the original question, investors as a group do not tend to do anything in particular in a bear market. And since you can never know if you are in bear market, any advice about what to do during a bear market is nonsensical.

The best advice I can give is to determine your proper asset allocation, which is one that properly balances your tolerance for risk with your long-term objectives. Stick with it through the good times and bad, and be sure to rebalance periodically if your portfolio drifts significantly from your target asset allocation. If you tend to react to bear markets (after the fact, by definition) by selling stocks, then you should consider hiring a financial advisor whose coaching can help you avoid these actions—they are detrimental to your long-term financial well-being.

No. All bonds, including U.S. government bonds, have at least two types of risk: credit risk and interest rate risk. Let's take them one at a time.

Credit risk is the risk that the borrower--in this case, the US government--fails to pay you the interest and/or principal on your bond. US government bonds are considered to carry very little credit risk because of the general strength of the US economy and the fact that the government (through Congress) has the power to tax in order to raise the money necessary to pay interest and principal on its borrowings. As important, the government (through its central bank) has the ability to create the money necessary to pay interest and principal, provided the bond is denominated in the home currency, i.e., the US dollar. Notwithstanding, in the summer of 2011, the S&P ratings agency lowered its credit rating on US Treasury debt from AAA to AA+. Egan-Jones, another ratings agency, has downgraded US Treasury debt three times, to AA-. While some think of US Treasury debt as "risk-free" in the sense of carrying no credit risk, clearly that view is not universally held. Countless governments have defaulted on their debts throughout history. 

Over time, the amount of US government debt outstanding has grown with the economy. Over the next 10 years, many (including the US government itself) project the debt to grow faster than the economy. Taken to an extreme, this could result in a default if Congress deems that preferable to the alternatives (e.g., cutting spending on entitlements such as Medicare, raising taxes, or asking the Federal Reserve to "print" more money). Of course, a default could have severe impact on financial markets and the economy, so almost all would prefer to avoid such an outcome. A dysfunctional legislative process could also lead to a default. For example, if Congress refused to increase the debt ceiling (the maximum amount the US government is permitted to borrow), the US could default despite having ample wherewithal to pay interest and principal on incremental borrowing. The initial 2011 ratings downgrade was attributed to such "brinkmanship" in Congress.

Interest rate risk refers to the fact that as market interest rates rise, the price of existing bonds drops. This is as true for US government bonds as any other type of bond. Imagine that yesterday you paid $1,000 to buy a new 30-year Treasury bond with an interest rate of 3%. Now suppose that today, new 30-year bonds (also costing $1,000) carry an interest rate of 4%. No one will pay you $1,000 for your 3% bond when they can now buy a 4% bond for the same $1,000. Your bond will have to drop in price until its return (stated as "yield to maturity") is equal to 4%. In our example, your bond would need to fall roughly 17% in price (to about $830) to make a buyer indifferent between your bond and a new 4% bond. In general, the longer the term of the bond, the greater is the price movement in response to a change in market interest rates. Of course, in our example, if market interest rates drop to 2% on new bonds, your bond will go way up in price. Interest rate risk cuts both ways.

So even if you assume that long-term US government bonds have no credit risk, you still take on a great deal of interest rate risk in holding long-term US government bonds. Rising interest rates may also have an adverse impact on the price of other types of investments, including stocks and real estate.