Ask Stacy: Should I Shun Stocks and Buy Bonds?

Here’s a recent reader question – maybe you’ve wondered about it as well:

I’m thinking of putting my 401K money (192,000) into Vanguard Intermediate Term Fund. Also $15,000 of savings into Vanguard Total Bond Market Fund. I am 72 and not willing to take a big risk with my money, but it is making under 1 percent now and I feel I need to venture out a little more. Can you give me a heads up if I am going in the right (fairly safe) direction? Thanks for any advice. – Carol

Carol isn’t alone in shunning stocks and buying bonds – bond investing has been outpacing stock investing for years.

Everyone knows the risks of investing in the stock market – the value of your stocks, or stock mutual funds, can evaporate in days; even minutes. But buying bonds also carries risk. The risk of bond investing: if interest rates go up, bond prices will go down. Think of a see-saw, with bond prices on one end and interest rates on the other. The farther out the maturity date of the bonds, the greater the price swing. So the lowest risk bonds (or bond funds) would be short-term, followed by intermediate, then long-term.

According to this MSNBC article from August, there are experts who predict a bond bubble is forming – in other words, that interest rates are too low, bond prices are too high, and sometime soon that trend will reverse: interest rates will shoot up, bond prices will go down, and bond investors will be creamed. Here’s part of the article:

Bill Gross of giant bond firm Pimco said that Treasuries had some “bubble characteristics” in December 2008 when 10-year yields neared 2 percent. Nouriel Roubini, who gained near celebrity status after calling the crash, warned of a bubble about the same time. In a letter to his Berkshire Hathaway shareholders last year, Warren Buffett compared the “U.S. Treasury bond bubble of late 2008” to the Internet and housing bubbles.

Here’s another dire warning from Wharton professor Jeremy Siegel and Jeremy Shwartz, director of research at Wisdom Tree Investments, also from August, from this article in the Wall Street Journal:

The possibility of substantial capital losses on bonds looms large. If over the next year, 10-year interest rates, which are now 2.8%, rise to 3.15%, bondholders will suffer a capital loss equal to the current yield. If rates rise to 4% as they did last spring, the capital loss will be more than three times the current yield. Is there any doubt that interest rates will rise over the next two decades as the baby boomers retire and the enormous government entitlement programs kick into gear?

There are, of course, other experts who disagree. They say that bonds are still the place to be. In fact, there are some who believe that since deflation is a greater risk than inflation, bonds are the only place to be.

So what’s the bottom line? Well, here’s my opinion: because interest rates are near zero, ultimately the path of least resistance is up, and that could put your bond mutual fund investment in jeopardy. Moving from a money market fund that pays less than 1 percent into an intermediate term bond fund will increase your income. But as rates rise, that extra interest you’ve earned will be offset by declining principal.

That being said, I don’t think rates will rise in the very near term – the economy is simply too sluggish. But if you’re investing in bond mutual funds, I’d be careful: Sooner or later, rates will rise, and that “safe” bond investment may not be so safe after all.

To stay as safe as possible, stay in your money market fund, despite the low rates. In other words, do nothing: that’s idea number one. But here’s idea number two: rather than keeping all of your money in the money market, keep half there and put the rest into the intermediate fund. That way if rates go down or stay the same, the fund will benefit. If rates go up, your money market will pay more. Either way, one investment wins. But my favorite idea is this one – divide your money into thirds: one-third in money market, one-third in intermediate bond fund, and one-third into a fund that offers big, blue-chip stocks that pay dividends. I’m talking about stocks like AT&T, Exxon Mobil, Chevron, Procter & Gamble, Johnson & Johnson, Verizon Communications, PPfizer, General Electric and Merck. These stocks aren’t terrifically risky. The fact that they pay dividends will help keep them from falling as much as other stocks in bad markets, give you some income and, when the economy ultimately improves, could make you some money.

Granted, investing in stocks – even in ones like those I mentioned – entails some risk. But so does staying in money market and making nothing, and so does going into bonds when interest rates could easily increase sometime in the future.

For more on my philosophy on investing, see Why You Should Buy Stocks and Houses Now. To see what stocks I currently own, see my personal portfolio.

Got more money questions? Browse lots more Ask Stacy answers here.