No Respect!

The Rodney Dangerfield of the investment landscape, bonds are usually characterized as boring investments for those without the cojones to step into stocks. But the name of the game is diversification, and with most of your cash stuffed into the stock market, it's easy to forget that even the most sophisticated stock jocks need to give bonds some respect . . . and a place in their portfolio. Sure, you'll swing for the fences with stocks, but you'll sleep better at night getting into bonds.

Simply put, a bond is a loan. When you buy a bond, you are lending someone, usually the U.S. government or a large company, your money. In exchange, you are entitled to receive regular interest payments. While bonds generally don't return as many dividends as stocks, they don't entail the same level of risk. If a company goes bankrupt, bondholders get paid first, even before stockholders. So although it's possible to lose money investing in bonds, they're generally considered less risky than stocks, especially when you buy them through mutual funds. Bonds are excellent for older investors who need an income for retirement. But if you're dreaming of a life of partying off your bond investments, put down that pipe! Unless you have Milken-esque millions at work, there's no way you could live off the interest income a bond generates, which generally averages between 4 and 9 percent.

Compare that return with recent tech stock gains, and bonds might seem boring . . . but when the stock market sags, savvy investors appreciate the steady income bonds provide. By putting even a small portion of your investments--say, 25 percent--in bonds, you're diversifying your portfolio and helping smooth out overall returns. For example, according to Ibbotson Associates of Chicago, a traditional stock portfolio would have returned 7.6 percent per year during the market doldrums of 1973 to 1983. During the same period, a diversified portfolio--one with a portion of its assets in bonds--topped the charts with a 10.59 percent annualized return.

Bond mutual funds come in all shapes and sizes, from super-safe U.S. Government bonds (called Treasuries) to risky corporate issues called "junk bonds." As with most investments, the higher the expected return, the higher the risk of losing principal. Bonds don't live forever, but expire, or come due, on the maturity date--the date when the entire value of the bond is repaid. A general rule is that the longer the maturity of the bond, the more volatile the price. If you're looking for a safe haven, stick with short-term bonds.

Since bonds are less liquid than stocks, most investors should go for bond mutual funds. Because returns on bonds are usually less than those on stocks, you should pay no more than a 1 percent management fee for bond funds. All this is listed in a fund's prospectus, or can be gleaned from Morningstar's Web site at http://www.morningstar.com

Jonathan Hoenig is a radio personality, market commentator and principal at Capitalistpig Asset Management in Chicago. Donald Monroe, an account executive at Capitalistpig, contributed to this column.