Is It Time to Jump off the Bond Wagon?

SEPTEMBER 16, 2008
Chandan Sengupta

It seems impossible these days to open a financial newspaper or magazine without coming across some grim warnings about the impending disaster in the bond market. All these experts may be right. However, proceed with caution. After these analysts led the public into the biggest stock market bubble and disaster of our generation, they're now seeing bubbles and disasters at every turn in an effort to establish themselves as the voice of reason. Their expertise is suspect. Also, be careful when everyone, especially every expert, comes to a unanimous decision. They generally listen to each other all day, and if people hear something enough times, it's human nature to start believing in it.

This isn't to say that the bond market is not a dangerous place now. It's probably more dangerous than it has been in a long time. But it doesn't call for dumping your bonds and running to the stock market as a safe haven, as some are suggesting. As always, you should have a long-term investment philosophy and plan, and if you're following these, you can ignore the experts and enjoy what's left of the summer. Remember: Slow and steady wins the race. Let's see how this philosophy applies to bond investing.

MAINTAIN STEADY PACE

Everyone needs to have a certain amount of bond-holding for portfolio diversification—it may be in the range of 20% to 30% for young people and 50% or more for people nearing retirement or already retired. If you fall in the young category and are holding a large amount of bonds because the stock market scared you away, you've now missed the sharp recovery the stock market has staged lately, and you may have missed an opportunity to make up some of your losses.

My suspicion is this rally won't last long, but that opinion is worth nothing. I don't know; nor does anyone else. The point is, you need to maintain a steady ratio of bonds to stocks in your portfolio, and if you've gorged on bonds lately, it's time to make some changes. An individual investor should probably never buy bonds of longer than 5-year or, at most, 7-year maturity. The additional risk you take by going longer is generally not justified by the small additional return you may earn.

So, if you're holding more bonds than you should be at your stage in life, it's time to cut back, starting with the long maturities. Put the extra money in a money market fund and slowly dollar- cost-average it back into the stock market over a period of time.You'll be earning next to nothing in the money market fund, but the first principle of making money is not losing a lot of it. So be patient.

Even if you are holding the approximate amount of bonds you should be holding, switch your longer-term bonds to maturities of 5 years or less. Remember: This is a 1-time adjustment you should be making. Don't try to play the game of shortening the maturity of your bond portfolio when experts predict interest rates will go up and then lengthening the maturity when they predict interest rates have peaked. Even Alan Greenspan is wrong about where interest rates are going, and he's the one who sets the short-term rates. Likely, you and your guru won't know any better.

STAY SLOW AND ON TRACK

If you want to be a successful long-term investor, follow the reverse of the philosophy that may be good in other areas of life: Don't just do something; sit there.

With all the daily information thrown at you, it's difficult not to keep making changes to your portfolio. If you're holding too many bonds, it probably started with first putting too much money in the stock market, then getting scared and taking out whatever you had left, then rushing into long-term bonds because money markets and short-term bonds were providing paltry returns, and so forth. This is too much activity— too many opportunities to make mistakes and pay too much in taxes along the way.

So, once you've adjusted your portfolio to the right mix of stocks and bonds and cut back the maturities of your bonds to reasonable levels, sit back and relax. The bond market disaster may come in 2 months, 2 years, or 10 years. But that too will pass.

Chandan Sengupta, author of The Only Proven Road to Investment Success (John Wiley; 2002), currently teaches finance at the Fordham University Graduate School of Business and consults with individuals on financial planning and investment management. He welcomes questions or comments at chandansen@aol.com.



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