Bonds as part of investment strategyBonds confuse most investors. The securities industry likes it that way.

The more you believe investing is just too complex to figure out on your own, the likelier it is that you will need the services of a “financial consultant.” Going down that road is often the beginning of a frustrating journey (for you-the consultant does just fine).

Fortunately, bonds are very simple to understand. Including them in your portfolio does not require the services of any broker or adviser. Here’s a basic primer on bonds.

Most Portfolios Should Include Bonds

Here’s a good rule of thumb: If there’s any possibility you will need 20 percent or more of your invested funds in twelve years or less, you need to have bonds in your portfolio.

The percentage of bonds is a function of your asset allocation (the division of your portfolio between stocks and bonds). Your asset allocation will affect your long-term returns more than any other decision you make, including market timing and stock picking.

Be sure to get it right. A good place to start is the asset allocation questionnaire on my website, Smartestinvestmentbook.com.

Bonds Play a Critical Role

You may be surprised to learn that the purpose of bonds is not to help you meet current and future income requirements. Bonds diversify your portfolio and reduce overall risk. Your goal is to increase the value of your total portfolio. If you view bonds as a source of income only, you will be tempted to take risks that could prevent you from reaching your investment goals.

These risks include extending the maturity dates of your bonds and compromising on the quality of bonds in your portfolio. Both are bad ideas. Bonds with longer maturities are subject to the risk of changes in interest rates. Bonds with lower credit ratings (and higher interest) have a greater likelihood of default.

Use Bond Index Funds or Bond Mutual Funds

Bond mutual funds (whether tied to an index or managed) have many advantages over individual bonds. The primary advantage with a bond mutual fund is diversification.

Any individual corporate bond has a risk of default, as we have seen lately with Lehman Brothers and General Motors (among many others). The way to deal with this risk is to diversify it away by owning a bond mutual fund, which holds a large portfolio of high-quality bonds.

Bond mutual funds also benefit from an economy of scale. They are professionally managed and have more efficient management of cash flows, better liquidity, and, most important, lower costs.

Finally, you should use only low-cost bond index funds for your portfolio rather than bond mutual funds.

Why? The bond markets are as efficient as the stock markets. Paying a bond fund manager to “beat the markets” has been a poor strategy in the past. For the five-year period ending on December 31, 2009, 84 percent of actively managed bond funds failed to equal their benchmark. This is a pretty dismal record, but it is not surprising. The higher cost of actively managed bond funds puts them at a distinct disadvantage against much-lower-cost bond index funds.

You should consider low-cost and broadly diversified funds like the Vanguard Total Bond Market Index Fund (VBMFX) and iShares Barclays Aggregate Bond Fund (AGG).

Dan Solin is a Senior Vice-President of Index Funds Advisors. He is the author of the New York Times best sellers The Smartest Investment Book You’ll Ever Read and The Smartest 401(k) Book You’ll Ever Read. His latest book is The Smartest Retirement Book You’ll Ever Read.

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