Riding the Bond Bull—With a Helmet

Most investors think of bonds as being less lucrative investments than stocks. They should think again.

When you buy bonds, you're lending money to corporations or governments in return for interest. When you buy stocks, you buy a piece of a company with the hope that it will grow in value. Because bonds issued by companies and governments that have good credit (yes, the U.S. government still has good credit) carry far less risk than stocks, investors are willing to accept lower returns than they would likely get from stocks.

Yet many individual investors aren't aware that bonds are providing better returns than stocks. We've been in a bull bond market for the past 30 years — not exactly your father's bond market. The stock market languished over the last decade, returning less than 2 percent annually. So we have a bull bond market coinciding with a bear stock market.

Over the last 10 years, bond returns have been so high and stock returns have dipped so low that Treasury bonds (those issued by the U.S. government) outperformed stocks by 5 percentage points. That doesn't sound like much of a difference. But remember: Stocks are supposed to way outperform bonds because they carry far more risk. Without stocks' historical performance edge, no one would want to leave the relative security of bonds to invest in them.

Yet, given the last decade, why do we think of bonds as likely to return less than stocks? Because of historical performance data. This data is important because the future of any type of investment is far more likely to resemble its long-term past average than its recent performance. (That's why fixating on current "winners" is foolish for long-term investors.)

This long look back shows that for taking the additional risk of investing in stocks over bonds, investors should generally expect substantially higher returns. Some respected analysts say stock returns should be more than 4 percentage points higher.

But this is assuming that there is enough time. As the past decade shows, expecting stocks to return more than bonds during shorter periods can be dangerous. At the same time, however, people investing for retirement 20 years from now shouldn't expect the bond bull market to continue indefinitely.

Odds are, historically low interest rates will rise over the next several years, depressing bond returns. Meanwhile, although the three- or four-year outlook for stocks is for low-single-digit annual returns, greater growth over the next seven or eight years is entirely possible.

This dual scenario would cause the pendulum to swing back, meaning that bonds would once again return substantially less than stocks. So cashing in a lot of your stock holdings now to buy bonds could be risky, depending on your age and when you plan to retire.

If you're planning to retire in 20 years, investing too heavily in bonds now could prove hazardous to your wealth, especially if you plan to draw heavily from your portfolio to pay living expenses early in retirement. One solution is to take advantage of the bull bond market without being trapped by it.

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