by Archie M. Richards, Jr., CFP^®
April 3, 2006

Ross writes, "You advise placing 20 percent of a portfolio in the Vanguard Long-Term Bond Index Fund. Aren't the prices of bonds with long maturities more volatile than those of short maturities? Since I'm 61 years old and approaching retirement, Vanguard's Total Bond Index Fund, whose maturities are shorter, would seem better for me. What's your reaction?

At 61 years old, Ross, you're just a youngster! If you're in any kind of reasonable health, count on living for 40 years - about the length of your working life. Forget about changing your portfolio upon retirement. The market doesn't care whether you're retired or not. Invest the best way all the time.

You're correct about the two Vanguard funds: The Total Bond Index Fund contains bonds with maturities greater than 1 year. The Long-Term Bond Index Fund contains bonds with maturities greater than 10 years.

You're also correct that long bonds are more volatile in price than short bonds. Greater volatility would seem like a bad idea, right?

Actually, it isn't. Greater volatility in your bond portfolio is more desirable. Here's why:

Bond-price fluctuations do not correlate with those of stocks. While stock prices are falling, for example, bonds may be rising. Bond-price changes aren't exactly opposite to stock-price changes, but any contrast helps.

To take the opposite extreme, let's say that for the bond portion of your portfolio you buy nothing but Treasurys due in only 30 days. While stocks are moving up and down a lot, the prices of the 30-day Treasurys, which hardly change at all, would not offset the stock fluctuations. As a result, the entire portfolio would become more volatile.

Long-term bonds, on the other hand, move up and down quite a bit - differently from stocks. Their price movements would partly offset those of stocks, making the entire portfolio less volatile.

You do need stocks in your portfolio; that's where the growth comes from. But you also need asset classes that have contrasting price movements, to reduce the stock volatility. Bonds with long maturities (and real estate investment trusts as well) fill this function.

Use long maturities for the bond portion of your portfolio. Long bonds may seem riskier. But actually, they make the portfolio safer.

The following studies, done a few years ago, make abundantly clear that trading in and out of stocks and mutual funds doesn't work:

• If you missed the 40 best-performing days of the stock market from 1963 to 1993, but otherwise stayed fully invested, your average annual return would have dropped from 12 percent to slightly more than 7 percent. By missing just half of one percent of the 7,802 trading days, the rate of return fell by 40 percent. Assuming $10,000 invested, the final balance after three decades would be $80,000 instead of a whopping $233,000.

• The records of 10,000 accounts at a large national discount brokerage firm were analyzed for the period from 1987 to 1993. The researcher, who was not given the client names, found that over the ensuing 12 months, the stocks sold outperformed those held by 3.4 percentage points. Investors sold the stocks they should have kept and kept the ones they should have sold. They'd have been better off buying a wide selection of stocks and just hanging on.

• From 1984 through 1995, the average stock mutual fund returned 12.3 percent a year. But the average investor in stock mutual funds earned only 6.3 percent a year. Why the difference? Investors sold the funds that had temporarily been losing and bought the ones that had temporarily been winning. They bought short-term winners just before they stalled and pulled out of short-term losers just before they rebounded. The trading cut the returns in half.

Don't trade stocks or mutual funds. You'll weaken your returns and may even turn gains into losses.