(Editor’s note: This is a huge disclaimer. I am not of the Islamic faith, but I have dug into the issue of Islam and investing because of some questions I had at a medical school finance lecture. Thank you to the medical school students who asked the question bonds and Islam, because I learned a lot through the process of tracking down the answer. What follows is my understanding of the Islamic faith and investing after talking with some Muslim attending physicians and doing some deep work on the web.)
Background on Stocks and Bonds
Stocks and bonds. They seem to go together like, well … peas and carrots.
Stocks (also called equities) are partial ownership in a company. Bonds are loans made to companies and municipalities. Many people view stocks as way to grow their money and bonds as a way to preserve their money. Modern Portfolio Theory uses bonds to stabilize a portfolio and mitigate the risk of stocks.
Finding Your Stock:Bond Ratio
Many people try to figure out the optimum stock:bond ratio. Most people use their approximation to retirement to determine how many bonds to have. The closer you are to needing your retirement savings, the more bonds you should have to preserve your wealth.
Unfortunately, many people use a mathematical formula to determine their ratio. Some say you should subtract your age from 100 and that is the percentage of stocks you should have. (If you are 30 y/o, you would have 70% stocks.) Some have even pushed that 100-age to 110-age or even 120 minus age.
I think this formula is a terrible idea for two reasons:
- One of the risks of an investment portfolio is not being aggressive enough to use the power of compounding interest to grow your money. Yes, your money is “safer” from not losing it, but you also miss out on the growth of stocks and you might not reach your targets.
- It completely ignores your personal risk tolerance. You may be able to sleep well at night in your 40s with 90% in stocks. (You can take a Vanguard investor risk questionnaire here.)
When I reviewed the Trinity Study (which brought us the 4% withdrawal rule) it seems that a 60% stock to 40% bond ratio was optimal in retirement, because during those 30 years in retirement, the chance of running out of money was 0.0%
I like those odds.
Where Should You Keep Your Bonds in Your Portfolio?
Stocks “pay” out earnings through capital gains and dividends. Long term capital gains (an investment over a year) and qualified dividends are taxed at lower income tax brackets.
Bonds pay you interest income and is taxed at your marginal tax bracket.
It makes sense therefor, to have your bonds in your tax deferred accounts (retirement), so that you don’t have to pay marginal tax brackets during your earning years.
It is this interest that causes issues within Islamic Finances.
A Brief Background on Islam and Finances
Personal finance is personal. And nowhere are finances more personal than when it comes to religion. There are some practices in the Islamic faith which affect personal finances. Some Muslims choose to be more/less strict when it comes to their finances, like people in every religion.
- Islamic finance follows Islamic Law (Sharia) which has some restrictions that align with their faith.
- There are many investments that are permissible (Halal). There are others that are in restricted sectors which include pork, alcohol, tobacco, weapons, gambling (maysir), conventional finances, and pornography. (The rationale seems logical, even to someone who has a limited understanding of any religion.)
- Interest (riba) is forbidden because it creates an unequal relationship between the borrower and the lender. The borrower is beholden to the lender in the form of having to pay interest. (Again, this makes sense, because the Islamic faith anything lent to someone should not appreciate in value, just because it is lent.)
Riba has a couple of different implications such as with home mortgages and bonds. There are some Islamic Mortgages that do not charge interest, but instead, cost more to make up the difference. There are also some “Islamic bonds” called Sukuk which have direct asset ownership which is allowable.
What are your “Bond” Options if you are Muslim?
There are a several options, two of which I mentioned above.
- Use Sukuk as your bonds.
- Use your Islamic Mortgage as a “bond proxy”. A bond proxy is a type of investment that gives you a predictable return. (You get an increase in your net worth when you pay down your mortgage which is a predictable return.)
- Keep your money in a savings account and donate the interest you earn. (There are some banking institutions that offer an interest-free savings account.)
- Some Muslims have used cryptocurrency as a bond proxy. Cryptocurrency adds an element of risk, which is left up to the Divine.
Where do You Buy Islamic Financial Products?
Vangaurd (one of my favorite investment companies) does have some halal related stocks within mutual funds, but it also includes others which would not be permissible.
It is difficult to find Islamic Financial products in the United States, but I have found two companies:
- Amana Mutual Funds Trust offered at Saturna.com. I know a physician who rolled her residency 403(b) into Amana Mutual Funds, but that is the extent of my interaction with the company.
- Another option is Shariaportfolio.com. I only know about them from what I read on the internet on their website.
What Would I do?
I like to invest … elegantly. (Ok, it is really, really boring and simple.) I am fine with that because even a second grader can beat wall street.
If I were to follow Islamic Financial Principles and attempt to adhere more strictly to the principles, then I would choose to do this for my “bonds” in my portfolio.
Assuming that I had a) Medical School Debt and/or b) an Islamic Home Mortgage
- I would use paying down the medical school debt and/or mortgage as my bond proxy.
- Once the medical school debt was paid off, I would continue to use my mortgage as my bond proxy. It would also make sense to pay off my loans as quickly as possible so that I was not beholden to the leader within a western-style student loan.
- I would then choose to keep some of my “bond” money in Sukuk bonds and some of my money in a savings account and donate the interest rate. I would weigh more of my money into cash because I just don’t have much experience with Sukuk. Over time, I might invest more into Sukuk, but I would have to see when I got along in time.
- I would be hard pressed to keep a significant amount of my “bond” money in cryptocurrency. But that is me. I don’t own crypto at this point, because I view it more as a speculation and not an investment.
Looking for Some Further Reading?
- Here is a background article on Sukuk at Investopedia.
- The article in this link is written by global capital market partner from the United Arab Emirates and goes into some of the advantages and disadvantages of Sukuk.
- Wealthdaily.com did a two part series on Sukuk which describes the background on Sukuk and how to invest in them.
- This final article is about the 5 Key Differences between Sukuk and Conventional Bonds.
If you know of any other company that offers Sukuk, please reply in the comments and I will add it to the article.