Many readers, especially those in or close to retirement, are writing in these days with a pretty straightforward question: How can I preserve my capital but still beat inflation?
That's a good question, given the volatility of the equity markets and the minuscule returns money-market instruments are currently earning.
One option is to hold a portion of your portfolio in well-diversified, high-quality bonds. For the vast majority of investors, the best way to hold bonds is in no-load mutual funds with low management costs. Moreover, the best funds will hold predominately intermediate-term bonds.
If you are a long-term investor, avoid investing in bond instruments that mature in under a year. These investments will earn less than 1 percent, and even with inflation as low as 3 percent, you lose 2 percent of your capital each year.
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Long-term bonds generally pay the highest interest, but they have more interest-rate risk associated with them. If interest rates increase, the value of long-term bonds will fall much more than intermediate-term bonds. For investors who place a high priority on preserving capital, a portfolio of predominately intermediate-term bond mutual funds will provide sufficient income to keep up with inflation and preserve capital.
Some advisers will recommend individual bonds rather than mutual funds - and for some people there are advantages to doing so.
However, unless you have a very large portfolio, it will be difficult to sufficiently diversify. The mutual fund investor receives the same diversification for a $1,000 investment as for $1,000,000. Funds have other advantages as well. With most bond mutual funds, interest is credited monthly, giving the investor the options of reinvesting the interest into the same bond fund, receiving the interest directly; or reinvest the interest into another mutual fund.
One of the major advantages of a bond fund over a typical stock fund is much lower volatility. In a discussion on the Vanguard website (www.vanguard.com), investment analyst Colleen Jaconetti pointed out that over the last 35 years, the worst year for bonds was 1974, and the bond market was down 2.9 percent.
In 2008, the Standard & Poors 500 stock index decreased more than 2.9 percent in 27 different trading days. Results in 2011 are similar. It is not unusual for common-stock mutual funds to fall for than 20 percent in one year. This clearly indicates the stability of bond investment compared to the volatility of common-stock investments.
Even despite the volatility in the stock market, many financial advisers recommend that investors maintain a much higher percentage of common stocks than bonds in their portfolios. And, looking at returns over 20- or 30-year periods, this seems to make sense. Unfortunately, if you look at returns over the last 10 years, you might be tempted to reconsider that philosophy.
In a comparison of 10-year annualized returns, Vanguard's 500 Index Fund - a stock fund that closely tracks the S&P 500 index - returned 2.21 percent, while three of Vanguard's conservative intermediate bond funds posted returns of between about 5.5 and 6 percent.
My portfolio still consists of roughly 30 percent common stock funds because I believe that over the next 10 years common stock returns may be better than bond funds after all.
However, the next 10 years may produce the same results. Great volatility in the stock market may continue, and investors who are interested in preserving capital and who want to stay ahead of inflation - especially investors close to or in retirement - should consider investing in high-quality, intermediate-term bond mutual funds as a significant part of their portfolio.
Contact columnist Elliot Raphaelson at elliotraph@gmail.com