Stocks once seemed so simple. Bonds were for nerds and codgers.
You could buy stocks with a few clicks of a mouse and could track their prices over the Internet or in the newspaper. Bonds were too complicated. Even to talk about them, you had to understand credit ratings, call provisions and other obscure lingo.
Even better, for a few years, stocks seemed to only go up, up, up at a double-digit pace most of the time. Bonds went up when interest rates were falling, but they went down when rates were rising.
While books such as "Stocks for the Long Run" and "Dow 36,000" flew off the shelves, believers in the New Economy didn't give bonds a second thought. Bonds were for banks, pension funds and oddballs.
Then, beginning in March 2000, an old nemesis known as risk returned to haunt stock investors.
Boring bonds enticing
Investors always had known that stocks were risky. Hey, sometimes Cisco System Inc.'s earnings might fall short of the whisper estimate, and its shares might drop for a few days. But systemic risk the idea that the stock market could go down for years at a time and that leading companies like Enron Corp. and WorldCom Inc. were not what they appeared seemed to be ignored.
The 9-11 attacks and the subsequent drop in the stock market convinced some people that they shouldn't have all their hard-earned investments in stocks. All of a sudden, the complicated, boring world of bonds looked like a nice place to be.
Financial advisers counsel against bailing out of the stock market entirely: You might be selling at the market bottom, and you'll probably need the long-term growth potential of stocks to reach long-term goals, such as retiring comfortably or paying for your 4-year-old's college education.
What you should do, though, is assess your time horizon and your tolerance for risk. If you set up a mutual-fund account for a 4-year-old who has aged to 14, you should be moving money out of stocks and into short-term bonds or money-market funds. If the stock market's slide is giving you headaches and is causing you to lose sleep, these are other good reasons to move money into bonds.
Don't dump all stocks
Mario DeRose, fixed-income strategist for Edward Jones, believes that everybody should have exposure to stocks, but he says everybody should own bonds, too.
And if you're nearing retirement age, he said, you might want 40 percent of your money in bonds. The bonds will preserve your capital and will provide income to live on. Meanwhile, owning a few stocks should help your overall portfolio to stay ahead of inflation as you live to a ripe old age.
Even young people who are starting to invest should put 15 percent to 20 percent of their money in bonds, DeRose believes. They might not be interested in the income, but they need to be concerned about diversification.
Events of the past two years have taught many people the value of diversification. For example, the Vanguard Total Bond Market Index Fund has risen 20 percent since mid-2000, and the company's giant stock fund, the Vanguard Index 500, has fallen 30 percent.
Over the long run, bonds tend to return less than stocks. But, because of years like 2000 and 2001, they smooth out the ride, enabling investors to sleep at night.
Even investors who understand the reasons for owning bonds have trouble understanding how they work.
"Stocks are easy: They go up, you make money. They go down, you lose money," says Colleen Denzler, a senior portfolio manager at American Century Investments in Mountain View, Calif.
"With a bond, people hear the news that interest rates are going up, and they wonder if that is good or bad."
How bonds work
The short answer is that higher interest rates are bad for bonds, and lower rates are good.
Here's why: If you pay $1,000 for a 5 percent bond today, it's going to earn $50 a year in interest. Suppose interest rates rise to 6 percent. No one's going to pay $1,000 for your $50-a-year bond because they could buy a new bond paying $60 a year. The price on your old bond will go down, in this case to $833, to reflect the new market interest rate.
Because interest rates are so important, investors keep an eye on the Federal Reserve. The nation's central bank controls the shortest-term interest rate in the economy, the rate banks charge one another for overnight loans.
The Fed cut rates 11 times in 2001, helping to make it a good year for bond investors. Most economists believe that sooner or later, it will have to push rates higher. Such a move could be bad for bonds.
But investors shouldn't be paralyzed by fears of what the Fed might do, says Bill Reynolds, director of the fixed-income division at T. Rowe Price Associates in Baltimore.
Rates on long-term bonds "didn't move down as much as short rates declined last year," Reynolds says. "It's highly likely, given a favorable outlook for inflation, that the long end of the market doesn't move significantly higher, either."
Besides, trying to time interest-rate moves is a dangerous game. Even the T. Rowe Price professional managers make only small changes in their portfolios based on the outlook for interest rates, Reynolds says.
How to invest in bonds
Let's say you're convinced that you need to move money into bonds. How do you do it?
Mutual funds offer a simple way. If you buy a core bond fund, such as Pimco Total Return (888) 877-4626 or T. Rowe Price New Income (877) 804-2315, you're letting professional managers make all the decisions that bond investing requires: corporate vs. Treasury, long term vs. short term.
Denzler has the American Century Ginnie Mae Fund (800) 345-2021 in her personal 401(k) plan. Its bonds are backed by thousands of ordinary home-mortgage payments. She says these bonds offer yields similar to intermediate-term corporate bonds, but without so much price volatility.
One drawback of mortgage-backed bonds: When interest rates are falling, people refinance their mortgages. The bondholders get some of their money back, and they have to accept a lower yield when they reinvest it.
Bond investors place a premium on predictability, so many people don't like shouldering that reinvestment risk. Denzler's view is that in a period when seemingly high-grade corporate borrowers such as WorldCom are downgraded almost overnight, home mortgages are a safe place for your savings.
Stay away from risky products, such as junk bonds and convertible bonds, advises Larry Swedroe, research director at Buckingham Asset Management Inc. They tend to fluctuate in price based on the issuing company's fortunes like stocks, and stocks are what you're trying to spread money away from.
"To me, fixed income should be the anchor of your portfolio, allowing you to sleep well," Swedroe says. "The vast majority of investors out there should only invest in government bonds or Double A and Triple A corporates."
For people in a high tax bracket, he would add tax-exempt municipal bonds.
If you've done homework, you might consider buying individual bonds rather than investing through a mutual fund.
Some experts say you shouldn't do so unless you have a lot of money to invest. Denzler says $500,000 is the minimum to diversify a bond portfolio adequately.
Reynolds doesn't recommend individual bonds unless you have "multiple millions of dollars" to invest. He says too many ways exist for a small investor to get fleeced.