Bonds can add diversification

Bonds can add diversification

Host : Why not?

David : I cover variable annuities in my program on stock investing, but for most people they don't offer much in the way of tax savings. Even worse, the new tax law turns most variable annuities from marginal winners to clear losers. But there was another problem.

Host : What was that?

David : His variable annuity invested in US stocks, and he already had a mutual fund which invested in US stocks. He thought he gained diversification because he thought variable annuities and mutual funds are different.

There are some differences in taxation and other aspects, but in his case the underlying securities are the same, and thus don't diversify his holdings.

He effectively put his eggs in two baskets, but then carried both baskets in the same hand. Not much reduction in risk.

Host : So what would be a better way to diversify his holdings?

David : If he had most of his money in stocks, he should consider putting some of his money in bonds.

Host : Bonds? But I thought stocks have done much better than bonds.

David : You're right, that's been true historically. But remember, you're looking for diversification. During the Great Depression stocks dropped almost 90 percent, but bond values almost doubled.

So bonds and bond mutual funds have their own rewards and risks. I explain these in my program on bond investing, but if you had invested in supposedly super-safe US Treasury bonds in the early 1970s, by the early 1980s your bonds would have lost half of their value.

Host : Ouch! But I thought things like bonds and bank deposits are safe investments.

David : In most respects bonds are safer, or at least less volatile, than stocks, and certificates of deposit have no price volatility.

Although bond mutual funds generally give you a better yield, sometimes you want to stick with good old bank CDs just to simplify your taxes, as I explain in my audio program on bond and fixed income investing.