Sudden Inflation Wreaks Havoc On A Traditional Portfolio

A sharp increase in inflation is bad for almost every asset class in the short term with two notable exceptions, TIPS and commodities. We’ll get to those in a second. First, we’ll examine the two traditional portfolio asset classes to see why they hold up poorly during inflationary periods.

Stocks - While it’s true that stocks are a pretty decent long-term inflation hedge due to the fact that companies will eventually be able to pass along production cost increase to consumers, they actually make relatively poor short- and intermediate-term inflation hedges. This is somewhat contrary to popular wisdom, but here’s why. When the cost of raw materials shoot up, companies have two options: they can either raise their own prices or take a hit to their own profit margins. Companies with strong economic moats such as Coca-Cola and Apple can afford to raise their prices – you don’t think kids are going to go without sugary beverages and hipsters without their Apple products, do you? – but the majority of companies can’t get away with passing along their increased costs right away. So their earnings suffer, at least in the short term. And when earnings suffer, stock prices drop.

Bonds - That bonds are vulnerable to inflation is fairly obvious. Simply put, nominal bonds pay a fixed rate of interest until maturity regardless of what happens with inflation. The longer until maturity, the more exposure a bond has to inflation risk. A 5% interest rate looks decent when inflation is 2% but it isn’t nearly as nice when inflation doubles to 4%. Short-term bonds aren’t as vulnerable because you don’t have to wait as long to reinvest the principal at a higher interest rate.

Investments That Hold Up Well To Inflation

Here are three alternative asset classes that hold up relatively well to sudden spikes in inflation.

Commodities – Raw material, crops, oil. The price of the stuff that fuels our economy is intimately linked with the consumer price level. It’s no surprise that commodities are positively correlated to inflation, even unexpected inflation. Unfortunately, there really aren’t any good low cost commodity mutual funds out there. Among open-ended funds, Pimco Commodity Real Return (PCRDX) is probably your best bet.

TIPS – Treasury Inflation Protected Securities are probably my favorite alternative asset class. TIPS are extremely well-correlated with inflation, which is kinda the point. Like regular bonds, TIPS pay a particular interest rate until maturity. Unlike regular bonds, the principal is adjusted twice annually in response to changes in the consumer price index. If inflation goes up, so does the principal. In the event of deflation, however, the principal goes down. Thus, the interest rate paid on an inflation protected security is in effect its guaranteed real rate of return. That’s a deal you really can’t get anywhere else. Of course, TIPS are only as good as the credit of the U.S. Treasury but I don’t think there’s any danger of a default anytime soon, despite the recent hysteria.

Gold – Yes, gold is an excellent inflation hedge and yes, it may have a small part to play in a diversified portfolio. Not that I’m a gold bug, or anything. I still think gold has too many negative characteristics to make a good long-term investment on its own. But as ballast to a broadly diversified portfolio, I think it can have its uses, particularly when unexpected inflation strikes.

Investments That Are Moderate Inflation Hedges

Here are two more investments that, while not perfect hedges against inflation, can do a decent job of hedging against moderate price spikes.

Real Estate – This could refer to both direct investment in real estate or REITS, although I prefer REITS. The reason I list real estate as only a partial inflation hedge is that prices are determined as much by rent levels as by land and material prices, and rents are determined as much by local supply and demand as anything else. It’s quite possible for rents, and thus prices, to fall even when inflation heats up. Of course, this can’t continue forever. Eventually rents will return to equilibrium with the overall price level.

Cash – Since cash investments are essentially very, very short-term bonds, they have very little inflation risk. Since cash securities mature so quickly, they can always be reinvested at higher rates. Still, this only goes so far. There reaches a point when financial institutions are no longer willing to pay ever higher interest rates on short-term cash deposits, regardless of what inflation is doing.

So it is.

A Breakthrough Study!

In a new study (opens as a pdf), Vanguard definitively answers the question we already knew the answer to: yes, sometimes if you are really, really good and lucky you can beat the market! Okay, that’s not exactly what the study says and it contains a few worthwhile insights. Let’s break it down.

Core And Explore Explained

Vanguard’s point revolves around the old core-and-explore theory of portfolio management. Traditionally, this has meant you should index within asset classes characterized by a very efficient market (large-cap U.S. and developed market stocks, for instance) and opt for active management in “less efficient” market segments (such as emerging markets, micro caps, etc).

Vanguard’s Take On Core And Explore

Vanguard turns this logic on its head, noting the data shows that indexing works very well in all market segments regardless of their reputed “efficiency.” Since the data clearly supports the notion that indexing is just as effective in, say, emerging markets as in the domestic market, indiscriminately opting for active management in for the developing market portion of your portfolio is unlikely to pay off. Rather, Vanguard’s approach is to focus on identifying talented and low-cost managers regardless of the part of the market they work in. That is, a talented manager in the large-cap U.S. stock space probably has a better chance of beating his benchmark than a below-average manager in the emerging market small-cap segment.

Making extensive use of back-testing, Vanguard’s findings lead some credence to their theory. Academics have long known that active managers do, on average, provide value through their stock-picking services. The kicker is that they don’t provide enough value to overcome the prices they charge! Put another way, the average stock-picker does seem to exhibit some small amount of skill. Unfortunately, the rewards will go directly into the skilled manager’s pocket and not to investors. This actually makes a lot of sense when you think about it. In an efficient market, the rewards of any endeavor are likely to go to the person who possesses this rare and special skill (talented stock picker) rather than to those who lack any special skills (mutual fund investors). Finding stock pickers who are both talented and who fail to charge a fee commensurate with their abilities is extremely difficult. Still, they do exist according to the research published by Vanguard.

But How Do You Find Skilled Managers?

Vanguard does give us a hint-a very important hint, in fact. If you want to increase your odds of beating the market, you’re more likely to find skilled stock pickers amongst the lowest-cost managers on the market and not the highest. This follows intuitively if you realize, as we do above, that stock pickers on average do out-perform the market slightly before accounting to fees. Since management skill is so difficult to come by, if your goal is to beat the market it makes much more sense to cut expenses rather than push for yet more skilled managers (which may not even exist!).

So far so good. We know that, all else being equal, we should look for skill amongst low-cost managers. But that’s not really enough information to consistently pick a winning mutual fund. Low costs will certainly increase your odds, but will they be enough to tip the scales in your favor? Probably not, especially not if the manager is “cheap for a reason,” so to speak. You’ve got to find a way to determine which of the cheap managers is undervalued and which are just bad. Unfortunately, Vanguard doesn’t provide us with any guidance here, making the study in-actionable mostly worthless. I suppose you could use past performance to try to identify which managers are likely to out-perform going forward, but a veritable mountain of evidence convinces us that’s a losing strategy.

So what’s the deal, Vanguard? Are you going to give us the recipe for your secret sauce or not? I’ll pay good money for it. Until then, I’ll continue to stick with index funds.

How Do Bonds Work?

A bond is a contractual obligation for a company or government entity to repay the principal of a loan at a pre-determined future date along with regular interest payments at specified intervals. There are plenty of bonds with unique features that make this a somewhat oversimplified explanation, but essentially what happens when you buy a bond is that you become a lender in the same way the bank who underwrote your mortgage was a lender to you. When you borrow money to buy a home, you know what your monthly payment will be (or at least the formula used to calculate it if you took out an Adjustable Rate Mortgage) and how long you’ll have to pay it. So it is with corporate and government bonds.

Bond Interest Rates Versus Risk

Most bonds pay interest twice per year, although there is some variation, and the length of time a bond will pay interest until the principal is repaid is called the bond’s maturity. In general, longer-term bonds will tend to pay a higher interest rate than shorter-term bonds and lower-quality bonds will tend to pay a higher interest rate than higher-quality bonds. This is because longer-term bonds have more credit and inflation risk than short-term bonds. That is, you’re more likely to run into problems the longer you lend out your money because while it’s relatively easy to predict what might happen a year or two from now, it’s much more difficult to predict what might happen 20 years down the road. Thus, long-term borrowers have to pay a risk premium to convince investors to part with their money for such a long period of time.

Similarly, the credit quality of the borrower plays a big role in determining a bond’s interest rate. Treasury bond rates tend to be lower than corporate bond rates because they are considered to be less risky. Junk bond rates, naturally, have to be much higher in order to tempt investors. The flip-side, of course, is that there is a much higher risk of default (meaning you don’t your money back at all) the lower you go on the credit quality ladder. For this reason, most experts highly discourage owning anything other than treasury and high-grade corporate bonds. Municipal bond rates are a special case. They usually pay lower rates than other bonds with similar characteristics because their interest payments are exempt from federal income tax.

Note: I highly recommend you familiarizing yourself with the Morningstar Bond Style Box.

Bond Interest Rates Versus Bond Prices

One of the most confusing things to most people is that bond prices move inversely with bond interest rates. When interest rates go up, bond prices fall. When interest rates go down, bond prices rally. Why? Because if I own a bond paying 5% when prevailing interest rates are only 4%, there’s no way I’m going to sell it for what I paid. I’m going to jack up the price so that the effective yield to the buyer is going to be right at the prevailing interest rate of 4%! Similarly, if interest rates go up to 6%, nobody is going to pay face value for my 5% bond. I’m going to have to lower the price if I want to sell it. The measure of how sensitive a bond fund’s price is to fluctuations in interest rates is called its effective duration.

What Do I Recommend For Your Bond Portfolio?

In general, a short- or intermediate-term high-grade bond fund should form the core of your bond portfolio. The best bond funds will own only high-quality bonds, sport low expenses, and have an average duration under 6 years or so. For investors who don’t mind a tad more complexity, I recommend a two-fund fixed income portfolio containing both a TIPS fund and a short- or intermediate-term nominal bond fund.

But never fear! I’ve decided to make things very easy for you. Below I’ve compiled a list of three legitimately-guaranteed investments. If you are being pitched a “guaranteed” investment not on the list below, there is a 99% chance you are being misled. Sure, there are exceptions to every rule and from time to time there probably are guaranteed or near-guaranteed investments other than those on the list below that do pop up. But it bears repeating and I cannot stress this enough, there is a 99% chance you are being misled! I don’t know about you, but I don’t like those odds. And let’s face if, if you are the type of person to be attracted to “guaranteed” investments, chances are you don’t know enough to be able to sort the good opportunities from the bad. In this situation, it’s best to just say no. Yeah, you may occasionally (once in a hundred years) miss out on some huge opportunity, but it’s much more likely the only thing you’ll miss out on is losing your life savings.

The Three Classes Of Legitimate Guaranteed Investments

So is there such a thing as a guaranteed investment? As it turns out, there is. There are three classes of truly guaranteed investments I’m aware of, all of them coming with some sort of explicit government guarantee, which is what makes them so safe. As you may have guessed, these are all low-yielding investments.

1. U.S. Treasury And Savings Bonds – The United States Treasury offers a variety of guaranteed bond products whose repayment of principal is backed by the full faith and credit of the United States Government, making them perhaps the safest investments on earth. These include short-term Treasury Bills, savings bonds, TIPS (Treasury Inflation Protected Securities), etc. While all longer-term Treasury bonds except TIPS do have inflation risk. or the risk that your interest payments won’t be enough to keep up with inflation, at least your principal is guaranteed. Those interested in absolute safety should stick with the lowest-yielding 90-day Treasury bills.
2. Certificates Of Deposit and FDIC-insured Savings Accounts – Following closely behind U.S. Treasury obligations on the risk scale are CD’s, savings accounts, and any other account insured by the FDIC, a branch of the federal government. The short-term risk-free nature of FDIC-insured accounts makes them ideal for short-term savings for purchases you’ll need to make within the next few years. A word about foreign bonds or CD’s: even though some of these investments may be guaranteed by foreign governments in no danger of defaulting on their obligations, these guarantees almost never extend to exchange rate risk. That is, while those UK bonds may be guaranteed to repay your principal in British Pounds, if the dollar loses value against the Pound you will still lose money. Hence, these aren’t guaranteed investments, at least from the perspective of the American investor.
3. Immediate Annuities – While immediate annuities are issued by private insurance companies and not the government, their value is usually explicitly guaranteed by state regulatory bodies up to a certain limit (similar to FDIC insurance). I won’t argue the merits of buying an immediate annuity (for the record, I believe an immediate annuity is appropriate for some modest percentage of your portfolio especially if your family is long-lived) and I won’t delve into the merits of the plethora of insurance riders you can buy in addition to the basic income stream, but I will say that these products are extremely safe so long as you stay under the state limits. Since state finances tend to be a bit shakier than federal finances and there is insurance party risk, perhaps I should stop short of calling these a truly guaranteed investment, but I believe they are close for all practical purposes.

Sadly, no amount of financial wizardry can undo the fundamental relationship between risk and return. Simply put, low-risk investments tend to be low-paying investments while high-risk investments tend to be high-paying investments. Any investment product proposing to violate this fundamental law of finance is most likely a scam! Put another way, you aren’t going to earn high returns with a low-risk investment. You’re just not. Accepting this statement as undeniable fact will go a long way towards helping you avoid being ripped-off. If you train yourself to expect high-return investments to also be high-risk investments, your BS detector will immediately go off anytime some scammer tries to convince you otherwise.

Principles For Avoiding A Scam (Any Scam)

If It Sounds Too Good To Be True…

Seriously, if it sounds to good to be true, it almost certainly is. Many people who fall for scams had this warning bell going off in the back of their minds the entire time but ignored it. Don’t ignore it.

Disbelieve Theories That Sound Logical But Don’t Have Independent Data To Back Them Up

Con artist is short for “confidence artist,” meaning they are skilled at gaining the trust of others. And it’s obviously easier to scam somebody who trust you than somebody who distrusts you. Hence, the best defense against con artists is to avoid any investment or system inherently depending on trust: trust of an investment manager (this rules out most active funds, btw), trust a salesman’s product will do what he says it’s going to do, etc.

But without trust, it’s impossible to accomplish anything. So if you can’t take people at their word, how do you know when something is legit? Simple: independent data. This could take the form of independent reviews of a product or service on the internet, consulting a trusted expert in the field (perhaps your nephew is also a financial advisor), or even an academic study on the topic by some esteemed professor. The point is that you should never take anybody’s advice when they have a direct financial incentive for you to follow that advice. If you ask an insurance salesman if you need more life insurance, he’s probably going to say yes. Similarly, a barber will probably tell you that you need a haircut. If you can’t verify the accuracy of any claim independently of the person making the claim, it’s best to pass. If a con artist can’t get you to trust him, he can’t con you.

Be Skeptical Of ANY Claim Regarding Low-Risk/High-Reward Investment Opportunities

As noted above, a fundamental relationship exists between risk and return. A con artist can no more circumvent these rules than defy gravity. Any claim that a high return can be earned with little risk should be met with intense suspicion for this violates one of the fundamental laws of finance. Do you really think you can earn a 40% return on your money with no risk from some guy

Always Compare Past Performance Claims To A Reasonable Benchmark (Usually Not The S&P 500)

One common trick salesmen use is to compare the performance of their product to an inappropriate benchmark, often the S&P 500 index. Now if the investment in question invests solely in the large-cap blend portion of the style box, the S&P 500 is probably a reasonable benchmark. Otherwise (and this is usually the case), it’s probably not. Who cares if an investment trust owning mostly small-cap emerging market stocks beat the S&P 500 over the past 10 years? That is an apples-to-oranges comparison with the sole intent being to trick you into thinking the investment you’re being pitched is better than it really is. This is a huge red flag because if the investment opportunity were really as good as claimed, they wouldn’t need to resort to misleading statistics in order to sell it.

Ask Yourself: If This Is So Profitable Why Do You Need Me?

This one should be obvious. Have you seen those banner advertisements around the web promising 20% monthly returns (or some other ridiculous number)? Chances are, you have. Now ask yourself this: if these people could really earn 20% per month on their money, why do they need to take on external investors at all? Earning 20% per month, a $1,000 initial investment would yield over $411 BILLION in 10 years! By investing only $1,000 of their own money, these “investors” could become the richest person in the world 10 times over within a mere decade. Tell me, with prospects like that, why do they need your money?

I’ll tell you why, because their system doesn’t work. Their profits come from scamming you!

What is a Stock Trading Simulator?

A stock trading simulator allows you to make paper transactions and follow the performance of the stock based on certain conditions being true. Some programs will allow you to enter different variables and then the computer will project the performance of the stock based on those conditions.

For instance, a change in interest rates can affect the price of a stock. Other external factors such as world politics and monetary policy can affect the stock market. A good stock trading simulator will allow you to get an idea how different changes can influence individual stocks as well as the overall stock market.

Unfortunately, playing with fake money and accumulating big profits is not the same as making real investments with real money. Mock stock trading doesn’t prepare you for the real thing. There are several reasons why your success or failure in a mock stock trading competition does not necessarily translate into the same success or failure in real life.

Assumption of Risk

When you buy and sell stocks in a mock stock market, you tend to take much bigger risks than you would normally do if you were actually buying or selling stocks with your own money. Paper trading or the simulation of real trades becomes more of a game or a study in the way the stock market can either reward you for taking big risks and being right or punish you for taking big risks and being wrong.

It is no different than playing a game like Monopoly. In that game, the idea is to accumulate all the property and wind up bankrupting everyone else. In real life, you would find it very difficult to control the housing market and gain a monopoly. Even Donald Trump would have a hard time playing Monopoly for real.

A Balanced Approach

Most prudent stock investors will create a portfolio that is balanced and diversified. Such an approach reduces overall risk and also reduces the chance for huge gains. In a mock stock market, one can experiment with individual stocks or with unusually high risk and high return stocks. You might get lucky in a new technology or biotech stock and think that you can do it again in real life.

Trying to repeat the same performance with high-risk stocks in real life is usually a losing proposition. For every one winner, there are probably at least 10 losers. You should never risk more than a small portion of your entire stock portfolio on highly speculative stocks.

What Does “Priced In” Mean?

Often times on internet message boards, individuals will be discussing the merits of investing in some stock or another. One poster will outline the factors that make some stock or another a particularly good investment. Perhaps that company has just discovered a new miracle cure or completed testing on the next Apple iPad killer. Inevitably, one of the other participants will dismiss all these positive developments, saying they are already “priced in.” What exactly is mean by that term, anyway?

It’s Expectations That Matter

Contrary to popular belief, stock prices are not set by past events but rather expectations of the future. What’s past is past. While that last blockbuster product may have made past stockholders rich, it’s not going to make that stock’s price go up in the future. Why? Because the effects of that blockbuster product are already well understood and its future impact on earnings relatively easy to predict. If everybody knows company A will earn about $1 billion dollars in profit next year because of that product, the price of the stock will rise to reflect the company’s expected results before those events transpire. By the time those sales are made and earnings actually booked, it will be too late to profit from them.

When somebody says some bit of news is “priced in” to the stock, what they are actually saying is that that specific bit of information is so widely known and anticipated that it will not cause the price of the stock to go up even if (indeed, especially if) the event transpires as expected. In order for the stock price to move up, the result would have to turn out to be even better than expected. Similarly, if it happens that the company’s results are still good but not quite as good as expected, the stock price will likely drop in response.

Example A:

Company A is expected to earn $500 million this quarter.

Thinks go exactly as expected and Company A does, in fact, earn $500 million.

There is no change in the stock price as a result since the result matched the expectation.

Example B:

Company B is expected to earn $500 million this quarter.

Things go even better than expected and Company B ends up earning $550 million.

Company B’s stock rises in value since the result was greater than the expectation.

Example C:

Company C is expected to earn $500 million this quarter.

Things go well, but there were a few hiccups along they way. Company C ends up earning only $490 million this quarter.

Company C’s stock declines in value since the result was less than the expectation. It doesn’t matter at all that $490 is still a very healthy profit. All that matters is that the result fell short of the market’s expectations.

As you can see, making money in the stock market is a lot more difficult than simply figuring out which companies will do well in the near future. Indeed, a company could do very well and its stock could still lose value were the market expecting it to do exceptionally well. It Is this dynamic that makes choosing stocks so difficult. Not only do you have to accurately guess how different companies will perform (a difficult feat, no doubt), you also have to be able to accurately guess how other investors judge how well those companies are likely to perform, which is an infinitely more difficult task. Still think you can pick stocks?

How Does a Savings Bond Work?

A savings bond is sold at face value. This means you pay $100 for a $100 paper bond certificate. United States savings bonds are government-issued bonds that earn interest over time. When an investor purchases a government-issued bond, they are technically investing in the government and the economy. In return for investing voluntarily, the investor will earn interest in the money they lent to the government. Interest rates do change over time. Banking institutions will keep updated government savings bonds interest rates posted to individuals coming to redeem their bond. Bonds begin earning interest when they are paid in full. Most savings bonds will continue to earn interest until their end-of-life date. This period ranges between 20 and 30 years.

EE Savings Bonds

While most United States government-issued savings bonds are sold at face value, EE bonds are sold at half their face value. This means you pay $50 for a $100 bond. While this may seem like a good investment, there is a catch. An EE savings bond is not worth its full face value until the bond has fully matured. Maturity periods will vary. Most bonds will mature within 20 years of being issued. If interest rates go up they can mature faster. If you redeem the bond before it has matured, you will not receive the bond’s full face value. You may also lose the last 3 months of interest accrued if you redeem your bond within 5 years of purchase.

Government-issued savings bonds became very popular during World War II. They continue to gain popularity during times of economic turbulence. If you want to set aside a savings for the future, consider the benefits of purchasing a US savings bond. While they do not earn much interest, they are low-risk investments that are extremely liquid. Prepare for the future and save for retirement.

The Risk: A High Inflation Rate

Honestly, relatively low inflation rate is harmful, but manageable by anyone with a relatively solid financial education. The real financial risk is in out-of-control inflation — inflation when it’s in the 6-10%+ ranges. That’s when cash is incredibly expensive, saving money for short-term goals becomes incredibly difficult, and the middle and lower classes are hit the hardest. This has happened just a few decades ago.

In 1980, for example, the official inflation rate actually peaked at over 13%. This is what even the government was reporting, even though governments often change their reporting tactics to give an optimistic outlook on economic trends, with the most profound changes happening in 1990. Just a few years of that can wipe out savings and change the entire economic environment of nations.

How to Prepare for Inflation

There are plenty of anti-inflation hedges, with one of the most common being TIPS from the Treasury Department — these are essentially Treasury securities that pay out what the consumer price index increases by. The risk is, of course, that the government would have a financial interest in under-reporting the current inflation rate. Of course, it’s still a relatively secure investment, and isn’t nearly as volatile as the anti-inflation alternatives.

You can also invest in gold, silver, farmland, and dividend stocks — all are popular anti-inflation investments. Of course, they also have their own risks — passively investing a set percentage of one’s income every month into them over time is the best way to both gain from their anti-inflation hedging characteristics as well as dodge “timing the market” risks.

Precious metals don’t pay an income, meaning you only profit — if ever — when you actually sell your assets. This means you make zero profit during a down market. If you put a portfion of your portfolio in silver, and then the price of silver drops like a rock, you’re either stuck with losses if you need the money or you’re stuck without the ability to use that part of the portfolio till the market picks back up.

This is itself a major risk, because it means you can’t liquidate without heavy losses. This is one area where farmland and dividend stocks win out, because they can provide income even when the market is underpriced.

As explained above, the best inflation-beating plan is one that is passive — your portfolio should always have at least some of the assets mentioned above. Having your portfolio prepared for high inflation before it hits is a safe way to make sure you’re actually ready when it does hit.

The question of whether to invest in short term bonds, long term bonds, emerging market bonds, corporate bonds, etc has become the subject of some debate of late, as if we needed to make this any more complicated. As with the stock advice above, most of the differences in opinion on which type of bonds to invest most heavily in is more style over substance. Just about any of the plans will work if you stick with it for the long term. Still, the path you choose could influence the ride quite a bit. Today, we’ll focus on the debate between short-term and long-term bonds.

Long Term Bonds

Strengths

• Higher On The Yield Curve - Following in the time-honored tradition of “more risk, more return,” long term bonds tend to sport significantly higher yields than their shorter-term brethren (excepting during periods of an inverted yield curve) to compensate for their higher risk of default and higher volatility.
• Protects Against Deflation - Inflation gets a lot more attention, but deflation can be far more damaging. The distant maturity dates of long term bonds will keep the interest payments flowing while prices fall, increasing the real purchasing power of your investment income. As an added bonus, you’ll make a mint with long-term bonds as interest rates fall in response to deflationary pressures.
• More Stable Income Stream - Long term bonds take longer to mature and so you (or your bond fund) will need to roll over the principal into newer bonds less often (bonds that may bear a lower coupon). Simple.

Weaknesses

• Very Sensitive To Interest Rates – Long term bonds have high durations, which means their prices tend to fluctuate wildly in response to relatively mild changes in interest rates. Most long term bond funds seem to hover around an effective duration of 10 years or so, which means the fund’s NAV will rise or fall about 10% for every 1% change in interest rates.
• Vulnerable To Inflation - When inflation picks up, interest rates go up as well. And guess what that does to bond prices? Yep, it pummels them.

When/Why You Should Own Them

In my opinion, you should only hold long-term bonds if you are

1. a retiree who needs a high and stable interest income, or
2. feel interest rates have peaked

I must admit that the deflation-protection point is very compelling. Some, such as Harry Browne with his Permanent Portfolio (not to be confused with PRPFX) specifically include long-term bonds for their deflation-protection properties. Most experts will grant that point; however, they will also argue (correctly in my opinion) that that short-term bonds, especially short-term government bonds, offer superior risk-adjusted performance.

Short Term Bonds

Strengths

• Inflation Resistant - Since short-term bonds have such short maturities, the market is pretty good at pricing in short-term changes in inflation. Barring a sudden hyper-inflationary environment, just how much can prices levels surprise you, anyway?
• Interest Rate Insensitive - As you might guess, short maturity implies short duration, which means your principal won’t fluctuate much with interest rates. Add to that the fact that interest rates tend to be a bit more stable over periods of less than a year or so and you’ve got a relatively stable asset class.

Weaknesses

• Low Yields – Short term bonds are very safe and thus don’t pay very well. But that’s okay.
• Volatile Yields - If interest rates drop, your income stream is going to drop soon thereafter. The upside is that your bond allocation will track rising interest rates just as quickly, of course.
• Vulnerable To Deflation - The opposite of long term bonds. You won’t get an extra real yield boost with short-term bonds since they turn over so quickly.

When/Why You Should Own Them

I believe the best answer to this question is “unless you have a specific reason not to.” Short term bonds tend to have a superior risk/return profile relative to long term bonds and are usually better diversifiers, to boot, since short term bonds tend to have much lower default risk than their long term counterparts. In short, if you’re having trouble deciding which type of bond to own, you’ll almost never go wrong choosing short-term bonds over long-term bonds.