The Next Investment Bubble

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There is no shortage of academic research touting the "efficiency" of the stock market. After all, with millions of investors jostling to buy and sell securities, surely all available information must be reflected in stock and bond prices.

But regardless of how well-oiled a machine our investing markets are, few can argue that speculation, irrationality, and bubbles are an inevitable part of life, especially in the short run. And don't look now, but there could be another bubble forming in a new area of the market.

Flight to safety
It shouldn't be too surprising, considering the scare that the stock market has given folks in the past few years, but apparently bonds are the shiny new toy that investors can't get enough of. According to a recent Wall Street Journal article, investors stuffed a record $229 billion into taxable bond funds through October 7 of this year. Adding to that total was another $63 billion directed into municipal bond funds.

These eye-popping inflows are even taking some bond managers by surprise. The WSJ article cites several managers as saying that inflows are above expectations and among the heaviest they've seen in decades. Moreover, some see bond demand as a sign that retail investors aren't moving back into the equity market to any great degree. In my opinion, that could be a pretty good indication of irrational exuberance for the bond market. And that means investors should be cautious looking ahead.

Slow and steady
While bonds have a place in everyone's portfolio, investors should be wary of all the hot money currently finding its way into bond funds. When it comes to investing, a good rule of thumb is to look where everyone else is running, and then run in the opposite direction!

While safety may be foremost on investors' minds, odds are good that this movement into bonds is too little, too late. Rates have been held at historic lows for quite some time now, and there's really nowhere else for them to go but up. It may not happen in the next few months or quarters, but when rates do eventually rise, that will place downward pressure on bond prices.

And just because bonds have had a good run over the past few decades compared to stocks doesn't mean that they will continue to dominate in the future. In fact, the whole idea of reversion to the mean makes it more likely that they will be left behind by equity returns in the coming years.

Of course, bonds can provide solid returns over the long run, but their main purpose should be to reduce volatility and protect capital, not provide long-term growth. That's the domain of equity investments.

Investors who have spent the better part of 2009 shunning stocks for the relative safety of bonds have missed out on some tremendous gains in the stock market. For example, big-name tech stocks like Google (Nasdaq: GOOG  ) and Cisco Systems (Nasdaq: CSCO  ) are up 72% and 50% year-to-date, respectively. Smaller stocks like industrial material players Sims Metal Management (NYSE: SMS  ) and Reliance Steel & Aluminum (NYSE: RS  ) are up 76% and 127% year-to-date. You won't see that kind of price appreciation from Treasury bonds!

Finding a middle ground
If you're one of those battle-weary investors who's been eyeing bond funds lately, stop and reconsider your reasons for wanting to step up your fixed-income exposure. If you have genuinely lost sleep over the amount of money you've lost in the latest downturn and are willing to give up some long-term return potential for a bit more safety, then it may make sense to bump up your fixed-income allocation. Just make sure to stick to broad-market mutual funds or exchange-traded funds like Vanguard Total Bond Market ETF (NYSE: BND  ) , Vanguard Intermediate-Term Bond ETF (NYSE: BIV  ) , or iShares Barclays Intermediate Gov't/Credit Bond ETF (NYSE: GVI  ) .

However, if you're simply following the crowd because you think bonds are the place to be right now, be careful. This corner of the market may be getting pretty inflated and could very well let investors down.

If your primary focus is building long-term wealth -- and for most of us, it is -- stocks should still form the core of your portfolio. Even folks closing in fast on retirement still need a decent slug of equities to sustain them over the long run. A harsh bear market doesn't change that. Bonds should be an integral part of your portfolio -- just don't count on them to be a cure-all for the market hangover we're all suffering.

For more insider investing and personal financial planning tips, take a look at the Fool's Rule Your Retirement service, which provides top-notch retirement and mutual fund advice. You can start your free 30-day trial today.

Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement investment newsletter. At the time of publication, she did not own any of the funds or companies mentioned herein. Google is a Motley Fool Rule Breakers recommendation. The Fool owns shares of Vanguard Total Bond Market ETF. Try any of our Foolish newsletters today, free for 30 days. The Fool has a disclosure policy.

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