IF INVESTORS EVER had any doubt about the beauty of bonds, the brutal bear market taught them an invaluable lesson. Back during the raging 1990s, bonds were about as hot as a Millie Vanilli CD. People complained that bonds were confusing, arcane and downright dowdy when compared with the smashing returns offered by stocks. And to a certain extent, they were right: While stocks have historically averaged 10.4% annual growth, bonds have slogged along at 5.4%.
But folks learned quickly that when the stock market turns against you, bonds can be your best friend.
After five years of 20%-plus gains, the Standard & Poor's index of 500 stocks plunged from 2000 through 2002. The index hadn't seen those types of losses since the four-year bear market that ran from 1929 through 1932. The Nasdaq Composite index, which is loaded up with technology stocks, fared even worse. But while stocks fell hard, U.S. Treasury Bonds rose — as they often do in times of turmoil on Wall Street. And in the end, more than a few aggressive equity investors learned the hard way why diversification is so important.
When stocks are in decline, even a relatively small amount of bond exposure elsewhere in your portfolio can do a lot to ease the pain. Check out our applet: From February to December 2002, the S&P 500 fell 20% as investors faced a continued economic slump and a steady flow of corporate accounting scandals. But when you click on the bond button, you'll see that amid this uncertainty, the bond market produced a 9% gain. Now, if you click on the 65/35 mix button, you'll see how a solid dose of bonds would have softened the blow of the equity portion of your portfolio during this time. A portfolio consisting of stocks alone dropped nearly twice as much as a portfolio with this mix of stocks and bonds.
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| | Sources: Dow Jones, Lehman Brothers |
And sure, in 2003 the stock gods once again shined on investors. With the S&P 500 gaining 28.7%, it could be tempting to forget the dark days of the bear market. But wise investors will remember that it's best to be prepared for sudden changes.
In other words, unless you're 40 or younger and have lots of time to make up for short-term losses in the stock market, you'd be silly not to diversify your portfolio with at least some exposure to bonds. It's true that figuring out how a bond really works is only slightly less confounding than learning quantum physics. But this section will help by giving you the basic background you'll need to invest in the fixed-income market wisely. It will also prepare you for our Strategic Investing section, which can help you formulate a bond strategy that makes sense for you.
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The lesson is clear: Unless you're 40 or younger and have lots of time to make up for short-term losses in the stock market, you'd be silly not to diversify your portfolio with at least some exposure to bonds.
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