The Dumb-Looking Move You Still Need to Make

Stocks have plummeted. Bonds have soared. If you believe in buying low and selling high, why would you even consider bonds right now?

For long-term portfolios, stocks have historically performed much better than bonds have. And although the past decade has seen bonds outperform stocks, there are compelling reasons to believe that the odds of a repeat in that regard are particularly low.

But that doesn't mean that you should banish bonds from your portfolio entirely. Here are some good reasons to keep at least a little bond exposure.

1. Stability.
No matter how appealing stocks may appear right now, most investors aren't comfortable with the volatility of having 100% of their money in stocks. The best way to smooth out stock fluctuations is with an asset whose returns are negatively correlated with those of stocks.

Since 1996, the average correlation between bond and stock returns has been negative. Especially during the two bear markets in the past 10 years, bonds have done an excellent job of counterbalancing portfolios against stock declines. For those seeking a smoother ride, owning bonds may well be worth accepting lower returns in a bull market.

2. Protection against deflation.
Investors have dueling concerns about future prices. Some believe that the government's massive liquidity injections will inevitably cause inflation. Yet others see the continuing fall in home prices, as well as rising unemployment and worsening prospects for workers, as evidence that deflation may come.

If inflation is your primary concern, then dividend-paying stocks such as Johnson & Johnson (NYSE:JNJ), United Technologies (NYSE:UTX), and Waste Management (NYSE:WMI) do a great job of protecting you. But stocks can perform poorly when deflation strikes, as products bring lower prices and profits fall as a result.

In contrast, bonds do really well with deflation. As prices fall, the purchasing power of interest payments and the repayment of principal at maturity becomes stronger. And as low as interest rates are now, a sustained bout of deflation could easily send them even closer to zero -- as the Japanese have experienced since the mid-1990s.

3. Safer ways to invest in distressed companies.
Right now, there are a huge number of large companies whose shares are trading at extremely low levels. As an example, look at these stocks, which have all taken large hits in the past year.

Source: Yahoo! Finance. AIG revenue reflects writedowns for investment losses.

Each of these companies is fighting for its survival. And even though low share prices give the potential for stellar returns for speculative investors willing to gamble on a bounce, there's also a substantial probability that you could lose everything by buying shares of troubled companies.

Sometimes, however, bonds make a better investment for a distressed company. Because bondholders often receive at least part of their money back even if a company goes bankrupt, bonds that sell at a discount can give you some added safety and still offer the potential for strong gains.

4. More assured income.
Recently, investors have turned more toward stocks for income, because dividend yields on many stocks are exceptionally high. The problem, though, is when companies cut or eliminate their dividends.

Although most bonds don't share the chance at capital appreciation that stocks enjoy, bond income does tend to be more stable than what dividends offer. A company can choose not to pay a dividend without any adverse consequence other than shareholder scorn, but skipping an interest payment has much more serious ramifications -- not just for investors but also for business operations.

None of these four reasons to buy bonds justifies having all of your money out of the stock market. But using bonds as part of your overall investing strategy still makes sense, especially if you target the types of bonds that best match your risk tolerance and investing style.

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