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One reason asset allocation strategies are so popular among investors is that they intuitively make sense. Most people think of the stock market as being the riskier place to put their money, but that they'll receive potentially greater rewards from investing in stocks. Conversely, the popular view of the bond market is that it's the place for conservative investors to park money they can't afford to lose, with bond buyers willingly sacrificing growth potential in exchange for the relative stability and steady income that bonds typically promise.
But recently, all the conventional wisdom about stocks, bonds, and asset allocation has gotten turned on its head. Even as the stock market has risen to all-time record highs, bonds have suffered big price declines that have awakened many bond-fund investors to the reality that their bond investments can actually lose money. With the specter of further rate increases in the future as the Federal Reserve contemplates an exit from its quantitative-easing bond purchases, one question arises: Do asset allocation strategies that advocate owning bonds still make sense?
The extent of the bond-market damage
Losses throughout the bond market in recent months have been substantial, and how much of that investors have suffered depends on exactly where they had their money. On the passive-index side, all-purpose bond ETF Vanguard Total Bond (NYSEMKT: BND ) has declined by almost 4% since the end of April, even after you take into account the income that the ETF has paid. Actively managed bond ETF investors haven't fared better, with the popular PIMCO Total Return ETF (NYSEMKT: BOND ) having lost 4.5% over the same time frame.
But long-term bond investors have seen truly massive declines. The iShares Barclays 20+ Year Treasury ETF (NASDAQ: TLT ) is off almost 14% since the beginning of May, as long-term rate movements have produced much larger capital losses in long-duration bonds. The sharp move has given bearish bond investors huge profit opportunities, as the leveraged inverse bond ETF ProShares UltraShort 20+ Year Treasury ETF (NYSEMKT: TBT ) has posted gains of more than 30% over the same period.
Even some bonds that many thought would be immune to interest rate movements have seen losses. iShares Barclays TIPS Bond (NYSEMKT: TIP ) , which buys inflation-adjusted bonds, has dropped almost 8% over the past few months. The reason has been that inflation isn't driving rates higher, but rather the expectation of tighter monetary policy and better economic conditions.
What bonds do
So far, strong returns from stocks have generally offset bond declines in balanced portfolios. But what's happened over the past few months should alert you to the potential for further capital losses from your bond holdings if the rising-rate trend continues, and further rate increases could come even if the stock market falters from its record-setting move.
But that doesn't mean eliminating fixed-income investments like bonds from your portfolio entirely. Instead, you can make some moves within the fixed-income arena to reduce your potential risk of loss while still giving you the benefits that bonds give you.
One thing to consider is to focus on shorter-term bonds. The interest rates they pay aren't as high, but they tend to produce smaller losses for a given increase in rates. In addition, using individual bonds rather than bond mutual funds and ETFs can help you avoid permanent losses, because if you hold the bonds to maturity, you'll receive the full principal amount back regardless of bond-market swings along the way.
An even better alternative for many is to use CDs rather than traditional bonds. In many cases, CDs pay better rates than high-quality bonds even though CDs are guaranteed by the federal government. If rates rise, your CD won't lose value, and you can even take money out early if you're willing to pay what is often a modest penalty. Similarly, savings bonds tied to the rate of inflation don't offer huge returns right now, but they do give you full principal protection and hold their purchasing power through automatic inflation adjustments over time.
Be smart about bonds
Discovering that bonds can lose value has been a painful experience for many investors, but they still belong in most people's investment portfolios. For money you need within the next few years, finding the right investment vehicle to avoid the volatility of the stock market is more important than ever. By being smart about which fixed-income investment to make, you can find the right balance between risk and return for your financial situation.
All that said, having too much money in bonds is also a big mistake. Millions of Americans have completely missed out on the huge gains in the stock market since 2009, putting their financial futures in jeopardy. In our brand-new special report "Your Essential Guide to Start Investing Today," The Motley Fool's personal finance experts show you why investing in stocks is so important and what you need to do to get started. Click here to get your copy today -- it's absolutely free.
Tune in every Monday and Wednesday for Dan's columns on retirement, investing, and personal finance. You can follow him on Twitter @DanCaplinger.