by Archie M. Richards, Jr., CFP^®
November 10, 2003

Darleen writes, "One of your columns (see www.archierichards.com for the column dated October 6, 2003) was addressed to a reader who wanted to invest $10,000. You wrote that Vanguard's minimum investment in any particular fund is $3,000 and recommended four Vanguard funds, as follows:

$3,000 Total Stock Market Index Fund 3,000 Total International Stock Market Index 2,000 Real Estate Investment Trust (REIT) Index Fund 2,000 Long-Term Bond Index Fund $10,000

My husband and I also want to invest $10,000. The Vanguard application states that the minimum investment for all Vanguard funds is $3,000. We therefore plan to invest $3,500 each in the Total Stock and the Total International Stock funds above. But for the final $3,000, which fund should we choose: the REIT or the bond fund?"

Vanguard's minimum for an IRA is $1,000, Darleen. But for a non-IRA, you are correct: It's $3,000. Thanks for writing about the error.

I consider lower prices and higher national income to be inevitable, due to the increasing pace of technological advance and improved government policies. As prices throughout the economy fall, interest rates will do the same. Long-term rates I see falling to about 2.5 percent.

Bond Fund: Let's say you buy a 20-year bond that pays 5 percent. (You can't buy just one bond; this is only an illustration.) You buy it for par, and it matures at par ($1,000 in both cases). For the entire 20 years, the interest payments remain level at $50 a year.

Five years after purchase, assume that long-term interest rates have fallen from 5 percent to 2.5 percent. The bond would be worth $1,300. If you don't sell, the value would gradually fall back to $1,000 during the final 15 years.

Mutual funds of bonds respond differently than individual bonds. While long-term rates fall from 5 percent to 2.5 percent, the value of a mutual fund that holds long-term bonds would rise by approximately 30 percent. Thereafter, the value would remain at the higher level for as long as the long-term rates stay at 2.5 percent. Over time, as individual long-term bonds mature to become short-term bonds, the mutual fund must continually replace its holdings with newer bonds that qualify as long term. The newer bonds have lower interest payments than the older ones. Therefore, the interest return from the fund would decline from 5 percent to 2.5 percent.

For the bond fund, then, you would see an initial 30 percent jump in price. Thereafter, the interest return would gradually fall from 5 percent to 2.5 percent.

REIT Fund: Deflation would cause real estate prices and the prices of REITs to decline. The dividend return from REITs would probably decline as well, but I see the dividends remaining above 5 percent.

Comparison: Benign deflation would cause the bond fund and the REIT fund to react in opposite ways. For the bond fund, the principal value would have a one-time rise, but the interest return would fall. For the REIT fund, the principal value would fall, but the cash returns would remain higher than those of the bond fund.

Solution: Buy the bond fund now. Go for the one-time rise in principal value. This would give you the following portfolio of Vanguard funds:

$ 3,500 Total Stock Market Index Fund 3,500 Total International Stock Market Index 3,000 Long-Term Bond Index Fund $10,000

In five or six years, switch from the bond fund to the REIT fund. This would capture the appreciation of the bond and avoid the subsequent decline in price back to par.

At the time of the switch, the principal value of the REIT fund would probably have fallen. It might go down further after you buy it, but at least you'd receive a handsome dividend return. The result should be no worse than continuing to hold the bond fund. There's a good chance you'd be better off.