Give bonds a little respect
By Michael Sincere • Bankrate.com

Every other Friday, we are running an excerpt from Michael Sincere's book, 101 Investment Lessons from the Wizards of Wall Street. This is installment 12 of 20.

During the last few years, bonds have not received as much respect as stocks. Because of an extended equity bull market and mediocre bond returns, a number of investors have reduced or eliminated bonds from their portfolios. The reason for this is simple: The average diversified stock mutual fund has earned about 30 percent annually in the past three years. During the same period, government bond funds have earned less than 8%.

When you buy a stock, you're buying part of a business. It represents ownership in a company. However, when you buy a bond, you are lending money to the corporation or government. A bond is considered a debt instrument; in other words, an IOU. A bond is a fixed-return investment, meaning it will pay a fixed-rate of interest for the life of the bond. Conservative investors prefer bonds because they provide a steady and predictable investment return.

There are many types of bonds, including tax-free municipal bonds issued by state or local governments, corporate bonds and money market instruments. When the bond matures, or comes due, the money the bond investor loaned to the corporation or government must be repaid. The longer the term of the bond, the more volatile it is. In addition, there is always the risk the bond will be downgraded by the credit-rating agencies. Bonds with the lowest ratings are called high-yield or junk bonds. Basically, for the opportunity to receive a higher yield, you take on more risk. (For more about bond basics, click here to read a review of The Bond Bible.)

So, do bonds have a place in the portfolio of individual investors? There are several advantages to having bonds in your portfolio, says Gary Goodenough, managing director of MacKay Shields, an investment advice firm in New York. "They generate substantial steady income and a lot of investors, especially middle-aged and elderly investors, rely on this income," he says.

In fact, by adding high-yield bonds to your portfolio, "you actually reduce the overall risk or volatility of returns of the portfolio," Goodenough says. Although high-yield bonds could lower the portfolio's expected return over the long run -- because stocks over time have returned more than bonds -- what you are looking for as an investor is a portfolio of assets that generate high return but generate them as independently of each other as possible, Goodenough says. "If you knew you could make 13 percent a year for the next 10 years, that wouldn't be so bad, would it?"

You can add many types of bonds to your portfolio either by purchasing them individually or by investing in a mutual fund; however, individual investors can only buy high-yield bonds through a mutual fund. It's often both smarter and safer to invest in a professionally managed high-yield mutual fund than in individual bonds because many investors don't have the time or expertise to check out the credit-worthiness of a company, which is an important prerequisite when buying bonds.

While you're evaluating the role of bonds in your portfolio, it's a good idea to assess whether it's time to rebalance your portfolio.

Rebalancing your portfolio simply means periodically bringing your asset allocation back to its original target mix. The most important reason for rebalancing is to maintain a consistent portfolio allocation. Without rebalancing, your asset allocation will fluctuate along with the market, creating additional risk.

When you initially select a plan for asset allocation, you must decide what level of risk and return you are willing to accept. For example, suppose you originally felt comfortable with a mix of 60 percent in stocks and 40 percent in bonds. Following a strong period of stock performance, you now find that you have 80 percent of your money in stocks and only 20 percent in bonds. Because your stock holdings are above your original allocation, your risk exposure increases. Conversely, if your stocks fall below their target level, your future earnings may be diminished. When you rebalance, you have to decide if you want to return to your original asset allocation plan or change it.

Jim O'Shaughnessy, CEO of O'Shaughnessy Capital Management, rebalances his fund's portfolio every 6 or 12 months, depending on the strategy of the fund. If it's an aggressive portfolio, he might rebalance in 6 months, and if it's a value portfolio, he might rebalance in one year. Most important to O'Shaughnessy, he rebalances according to the calendar, not to outside events. "We have no idea what is going to happen to the market tomorrow -- up, down, or sideways -- but we have good information about what is going to happen over the long term. Therefore, we are going to use that information to rebalance annually."

There's another reason for rebalancing your portfolio: The portfolio you choose at age 35 may no longer be adequate when you reach 55. If your investments are in taxable accounts, of course, taxes should be a consideration. Instead of selling shares of well-performing stocks, which would result in capital gains, some pros suggest you contribute more to lagging investments until you bring the allocation back into balance. Of course, at some time, you might have to sell an investment if it no longer fits your strategy or is performing poorly.

Most financial experts suggest you rebalance your portfolio on an annual basis. The start of the new year is always a good time to take a fresh look at your portfolio, review your portfolio's risk exposure, and determine if your asset allocation needs changing.

-- Posted: Dec. 1, 2000