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If stocks crash and burn, bonds are good parachutes


Here's something investors take on faith. Over the long term, stocks are always better than bonds.

That's the same as saying that stocks are sure things, at any price, as long as you hold them long enough. And if that's true, why would anyone bother with bonds at all?

Bond funds have done better than stocks, so far this year. They're up 1.6 percent, in a period when the Standard & Poor's 500-stock index went nowhere and the Nasdaq fell 5 percent.

Bonds beat stocks in 1980-1990, when interest rates plummeted and bond prices soared.

But you don't own bonds to outperform. Their primary function is security.

They generate a predictable income, which is valued by retirees. And they support your net worth when stocks go bad.

Stocks haven't gone bad in nearly 20 years, so modern investors barely give bonds a thought. We've all become long-term players now (or so we think).

But here's my personal heresy: In the long run, stocks do not always succeed.

Long-term studies of "stocks" refer to the U.S. market as a whole, usually measured by the Wilshire index of 5,000 stocks. But you need an index mutual fund to get the same performance. Any of the individual stocks you own can do poorly over 20 years or even tip into bankruptcy.

Furthermore, owning index funds doesn't necessarily reduce your risk. It depends on what you mean by risk, says Mark Kritzman of Windham Capital Management in New York. For example:

The longer you invest in "the market" (that is, an index fund), the smaller the chance that you'll lose money when you sell. That bolsters the popular belief that, eventually, stocks are safe.

But the longer you hold, the greater the chance that - at some point - you'll suffer a major loss. That's because markets plunge from time to time, and may take years to struggle back to a rising track.

Veterans of the Crash of 1987 imagine that rotten markets pass like a summer storm. But in the late '60s and '70s, stocks went nowhere for 10 or 15 years.

And finally, the longer you hold stocks, the greater the chance that a loss, when it comes, will be of truly awful size.

That's another way of saying that stocks are always risky, no matter how long you invest. You could invest, fear-free, for 20 years, then suffer a drop of 40 percent just when you're ready to retire.

History shows no U.S. stock losses over 20-year periods. But that doesn't mean it couldn't happen. Anyway, how would you feel - at any time - if your nest egg dropped by 40 percent?

Ultimately, "it's a question of pain, not gain," says economist William Sharpe, Nobel Prize winner and professor emeritus at Stanford University's Graduate School of Business. How bad would you feel if you fell into one of the market's occasional black holes? How much would it change your life?

If you could truly shrug off the loss, by all means keep all your long-term money in well-diversified stocks. But if it would wreck your retirement, your kids' college plans, your marriage or your mental health, it's dumb to invest as if stocks were safe. You need a cushion, just in case.

What should that cushion be? If inflation soars, Treasury bills or money-market funds would be the best defense, because their interest rates would keep going up. If inflation stays low, you'd do better with bonds because they yield more.

No one can know what's best in advance. Right now, however, the pros are making a case for bonds. The share prices of bond funds have fallen since interest rates began to rise (especially on high-yield funds). But they'll recover, when the rate squeeze ends.

Marilyn Cohen, president of Envision Capital Management in Los Angeles and author of the new book, "The Bond Bible," thinks that baby boomers will soon discover bonds.

"As they turn 55, they're going to start looking at their exit strategy for retirement," she predicts. "Stock-price volatility wears you out. As you get older, you want more predictable income from your investments."

Investors in taxable accounts should be looking at tax-free municipals. You can get 5.3 percent on 10-year, AA-rated bonds. That's almost as much as the 6.12 percent paid by comparable Treasuries - and the Treasuries are taxable.

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