Avoid the Bond Fund Trap
Investment professionals often preach to the masses (that’s us) that two of the biggest killers of investment returns are fear and greed. (That would be our fear and greed. Investment professional tend to overlook the impact of their own greed.) I’m familiar with these very human frailties. I’ve struggled with my own fear of loss as in impediment to making rational and timely financial decisions.
In my book, making investment decisions based on fear and engaging in risk-adjusted behaviors are distinct concepts. A fearful investor may tend toward doing nothing, even in the face of overwhelming evidence that something should be done. An investor that modifies his or her investing behavior based on risk tolerance is more likely to make rational decisions. In our case, I adjusted our equity allocation downward during the market decline, putting new money into cash-equivalents. I also sold some high risk financial stocks before the bottom completely fell out. This made sense for us because of our age.
This brings me to the ultimate topic of this post: avoiding the bond fund trap.
It seems that fear is still guiding the investment behavior for lots of us. My basis for this statement: In the past year, investors have funneled $506 billion into mutual funds. You might be wondering how that manifests fearful investing. The answer lies here: Of the $506 billion invested in mutual funds, $409 billion was put into bond funds. (That’s 80% in bond funds for the tired brains out there.) (Source)
This brings me to the “trap” part of my warning. The average investor sees the word “bond” and immediately thinks “safety” compared to stocks. Heck, “bond” just sounds more secure. That’s my theory of why bond funds are so popular now compared to equity funds. The fearful investors put their money in bond funds, believing that bond funds are “safer.” But that’s not necessarily true.
Granted, a highly rated bond is clearly “safer” than a stock in that you are less likely to lose your investment. The caveat is that you must hold the bond until maturity.
Many casual investors assume that because bond funds own thousands of individual bonds, the funds are also “safe.” This is a false assumption. First, bond funds rarely hold bonds until maturity or if they do, the bonds mature at different times. This means that the market value of the fund shares is subject to fluctuations in the market (trade) value of the underlying bonds. The bond market values are subject to interest rate risk, among other factors. If interest rates rise after an investor buys shares in a bond fund, the share value is highly likely to decline in proportion to the increase in interest rates. This is because the market values of the bonds owned by the fund are falling with increases in interest rates. (An exception may be a bond fund that holds only bonds with a short duration until maturity.)
In summary, a belief that bond funds are “safe and secure” is a trap for the fearful investor. In some circumstances, such as an economy experiencing interest rate volatility, bond funds can be riskier than equity funds.
So avoid the bond fund trap. Do not let fear control your investing behavior. Look beyond your fear (and your greed) when making financial decisions. If you are incapable of controlling your emotions when planning your financial future, get some help. You will be glad you did.