Why does this matter? Because it explains why bond funds have done so well over the past 18 months. Interest rates are near historic lows. That means that a $100 bond issued by a company with a 6% interest rate is worth more than $100. The mutual fund gets to show that higher value on its books and may even sell the bond to make an immediate profit. This effect is compounded by the fact that bonds are less volatile than stocks, and investment money has to go somewhere. As more money goes into bonds, the prices go up (driving interest rates down), and making the bond funds look even more profitable.
Should you buy bond-based mutual funds? Sure. But not just today: always. A portion of your investments should be in bonds just to protect a portion of your investments from the type of stock market chaos we have seen over the past two years. The ratio you invest in bonds should be based on two items: your time to retirement and your tolerance for risk.
The farther away your retirement is, the more time you have to wait for the stock market to recover. Since stocks normally outperform bonds, you benefit from the better return and have your nest egg grow faster. As you get closer to retirement, you should shift more of your investment from stocks to balanced funds: bond funds and money market accounts. These investments don't see the highest returns, but they also are not as liable to collapse.
The exact percentages for different investments at different ages vary according to whom you ask. But it always has to be balanced against your tolerance for risk. Some people don't mind losing $20,000 in a year if they are confident they can make $30,000 a few years down the road. Some people get heartburn over a $5,000 drop. Bonds reduce overall risk, but limit future growth. Either way, your investments should not cause you grief; they should be a source of comfort and hope. If you are more like the first person, then you can put most of your money in stocks. If you are more like the second, then you need to keep more in bonds and other conservative investments.
The market collapse and the great performance of bond funds has made people re-examine bonds as an investment. The stellar recent performance of bonds is partially due to low interest rates, combined with the lingering fear of the stock market. While bonds should always be part of an investment portfolio, most people should not move exclusively to bonds. Remember, when inflation returns, the Federal Reserve will raise interest rates. All those 4% bonds will lose value as the interest rates go to 7% or 8%. When the economy regains its footing, stocks will start performing again, causing stock prices to rise.
As always, remember that any loss you see now is merely a paper loss. When you sell and transfer the money to a different investment, you lock in the loss and make it real.
That doesn't mean you should not ditch bad investments; it just means you shouldn't chase the trends with your investments because if you get a late start and your legs aren't long enough, you'll get left behind.