Bonds have a place in your portfolio

Investors have poured money into the bond market this year as they have watched their stock holdings vaporize. The latest mutual fund statistics show that investors are selling more shares of stock funds than they are buying, while at the same time throwing billions into bond funds.

Should you do the same? Maybe, but not for the same reason the crowd is bulking up on bonds. Market manias have a way of making the average investor sometimes do the right things for the wrong reasons. Why should you get into bonds? That’s easy: they are a necessary component of a well-diversified, long-term investment portfolio.

Why are investors stampeding into the bond market now? Because they are panicking over their stock losses and want something “safe” and “steady.” Unfortunately, their timing is off. They should have owned bonds three years ago, when the stock market was roaring and the bond market was suffering. At that time, however, money was pouring into stocks and average investors were shunning bonds. Investors could not understand why they would want to earn an interest rate of 6% when stocks were returning 20% to 30% per year. Again, the answer is easy: to moderate portfolio risk and to take advantage of unpredictable changes in the stock markets.

Just at the time when few investors were putting money into bonds, the stock market began to tank and bonds began their run. After losing money in 1999, long-term U.S. government bonds rallied, gaining almost 22% in 2000, 4% in 2001 and 7% through July of this year. Those returns certainly look appetizing when compared to losses suffered in the stock market from the beginning of 2000 until now.

That could make a student of market history decide against buying bonds now. They know that following the crowd is not usually the right thing to do—the panic move from stocks to bonds may be happening just as the stock market begins another long-term rally. Maybe and maybe not: the problem is that the future is unpredictable.

Just a few months ago the stock market was looking a little better and the general consensus was that an improving economy would lift stocks and lead to renewed inflation. The Federal Reserve Board, so the predictions went, would have to start raising interest rates soon, something that is usually bad for the bond market.

What a difference a few months makes. Instead, stocks collapsed, bonds gained, and predictions changed. All of a sudden the consensus was that the Fed will cut rates to revive the economy. Which will it be? That’s the point: we don’t know and it isn’t worth trying to predict.

Therefore, a prudent investor will maintain a balanced portfolio at all times. The length of time investments will be held and the investor’s own risk propensities will determine how much of the portfolio to allocate to stocks and bonds. Investors also have to acknowledge that both markets are risky. Interest rate increases cause large drops in long-term bond prices.

Investment theory suggests that the risks in long-term bonds are not adequately compensated. For that reason, investment experts suggest keeping your bond allocation toward the short end of the maturity scale, and taking your risks in the stock market.