A reader writes in to ask:

“I use Vanguard’s Total Bond Market Index Fund for my bond allocation, but I noticed that it doesn’t include any municipal bonds. Can you walk us through municipal bonds — how they work, who should own them, where you should put them (taxable account? IRA?), and which ones should you own (e.g. a general fund or a state-specific fund)?”

Bonds issued by U.S. states or municipalities are exempt from federal income tax. These bonds are referred to interchangeably as tax-exempt bonds, municipal bonds, muni bonds, or even just “munis.”

Because of their tax-exempt status, the market typically prices muni bonds so that they have lower yields than taxable bonds of a similar credit quality.

Who Should Use Muni Bonds?

Tax-exempt bonds only make sense when investing in taxable accounts. In other words, if all of your investments are in tax-sheltered accounts — 401(k), IRA, etc. — your investments are already protected from taxes, so there’s no reason to accept municipal bonds’ lower yields.

But even for investors who can’t tax-shelter all of their investments, muni bonds still aren’t necessarily the best bet.

Because of stocks’ built-in tax-efficiency (due to the maximum 15% tax rate on dividends and long-term capital gains), it generally makes sense to tax-shelter all of your bonds before tax-sheltering any of your stocks. As a result, municipal bonds typically only make sense if:

1. Your desired bond allocation is larger than the amount of tax-advantaged space you have, and
2. You’re in a high enough tax bracket that your after-tax yield on taxable bonds would be less than the yield on muni bonds of similar credit quality.

Example: James has $300,000 in a taxable account and $100,000 in an IRA. His desired allocation is 60% stock, 40% bond (that is, $240,000 stocks, $160,000 bonds for his $400,000 portfolio).

Even after James invests his entire IRA in bonds, he still needs to own $60,000 of bonds in his taxable account in order to satisfy his desired bond allocation. If James’ marginal tax rate is high enough, muni bonds could provide a higher yield than the after-tax yield on similarly-rated taxable bonds.

Of course, as with all broad investing guidelines, there will be exceptions. For example, an investor in a high tax bracket might want to own muni bonds in a taxable account and stocks in her retirement plan at work if the retirement plan has inexpensive stock funds but only super-high-cost bond funds.

Should You Own a State-Specific Muni Bond Fund?

While municipal bonds are exempt from federal income tax, they’re usually subject to state income tax. However, if you buy a bond issued by your own state or by a governmental body within your state, the bond will usually be free from state income tax as well.

State-specific muni funds (e.g., Vanguard California Intermediate-Term Tax-Exempt Fund) exist in order to invest in bonds within a particular state to take advantage of this exemption from state income taxes.

So, if you have a high state income tax rate, there’s a significant tax advantage to sticking with muni bonds from your own state. The downside is that you’d be sacrificing some degree of diversification.

The maturity of a fixed-income investment is simply how long the instrument lasts. For example, a 10-year Treasury bond has a 10-year maturity.

Duration is a slightly more complicated concept, but it’s very useful for understanding how bonds and other fixed-income investments work.

The duration of a bond is the weighted-average period of time before the cash flows involved are received. (Technical note for those curious: The weight for each period is not based on the nominal value of the cash flow received at that time, but rather the present value of the cash flow.)

How About Some Examples?

A CD that has a 5-year maturity has a 5-year duration as well, because the only cash flow involved — the payment received when the CD matures — will be received in five years.

In contrast, a 5-year Treasury bond will have a duration that’s less than its 5-year maturity. If sold for face value, a 5-year Treasury bond with a 1% coupon rate will have a duration of 4.89 years. The reason the duration is less than 5 years is that some of the cash flows (specifically, the interest payments) will be received prior to the bond’s 5-year maturity.

A 5-year corporate bond with a higher yield will have an even shorter duration. For example, if sold for face value, a 5-year bond with a 5% coupon rate would have a duration of 4.49 years. Despite having the same maturity as the lower-yielding Treasury bond, it has a shorter duration. The reason for this is that a larger portion of the bond’s overall value is received prior to maturity (because, due to the higher yield, the interest makes up a greater portion of the total cash flows).

Conclusions: The shorter the maturity of a bond, and the higher its yield, the shorter its duration.

Why Bond Duration Matters

For most investors, the primary importance of bond duration is that it predicts how sharply the market price of a bond will change as a result of changes in interest rates. Specifically, when interest rates rise, a bond’s price will fall by an amount approximately equal to the change in the applicable interest rate, times the duration of the bond.

For example, if a 10-year Treasury bond has a duration of 9 years, and interest rates for 10-year Treasuries increase by 1%, the bond’s price will fall by ~9%. (Conversely, if 10-year Treasury bond interest rates fell by 1%, the bond’s price would increase by approximately 9%.)

The same goes for bond funds: The average duration of the fund tells you how sensitive the fund will be to changes in market interest rates.

For example, Vanguard’s Extended Duration Treasury ETF holds nothing but Treasury bonds, but with an average duration of 27 years, it’s extremely high-risk. When interest rates crashed in 2008, the fund put up a positive 55% return. Then in 2009 when rates came back up, it had a negative annual return of almost 37%.

In contrast, Vanguard’s Short-Term Investment Grade fund (with an average duration of 2.2 years) is much lower-risk, despite the fact that that the credit quality of its bonds is meaningfully lower. In the last 15 years, the fund has only had a negative return once. And that loss was a not-exactly-catastrophic 4.74%.

Conclusion: When considering a bond fund, to get an idea of the risk level involved, you need to check not only the credit quality of underlying bonds, but also their average duration.

I received this question via email a couple days ago:

“What do you think of Vanguard’s Small-Cap Growth Index Fund? Looking on Vanguard’s site, it looks like it has had very good long-term performance (5 and 10 years), and Morningstar gives it 4 stars.

I know it’s an aggressive fund, but I’m a young investor, so I think that might be OK. What do you think?”

I liked this question because it’s a perfect example of a common investing mistake: Building a portfolio backwards by starting with investment selection.

A better way to build your portfolio is to first decide what asset allocation you want to use, then select which investments you’ll use to meet that allocation. After all, a fund can be a great fund, but have absolutely no place in your portfolio.

For example, I think Vanguard’s Inflation-Protected Securities Fund is excellent. It’s a low-maintenance, low-cost way to invest in TIPS. But I don’t use it because I don’t want an allocation to TIPS in my portfolio (because I’m not very exposed to inflation risk).

Choosing Your Asset Allocation

As we’ve discussed before, when choosing your asset allocation, the most important questions are:

1. What portion of your portfolio do you want in stocks (as opposed to bonds or cash)?
2. What portion of your stocks do you want to be invested in the U.S. (as opposed to internationally)?

After you have answers to those questions, you can move on to selecting investments to meet that allocation.

Or, if you want to, you can further customize your allocation in any of several ways–adding an allocation to REITs, tilting your stock holdings toward small-cap and/or value stocks, including an allocation to TIPS, etc. But you don’t have to.

Selecting Investments

After you’ve decided what allocation you want to use, it’s time to go ahead and pick funds to meet that allocation. My approach to investment selection involves just two rules:

1. In each asset class (U.S. stocks, international stocks, bonds, etc.), select the lowest-cost option available.
2. Use as few funds as possible.

When selecting investments, it’s important to remember to view your portfolio as a whole rather than viewing each account as a separate portfolio. By doing so, you can simplify your holdings dramatically (because you won’t need to hold multiple funds in each account), and you may be able to reduce your costs as well.

No Need to Complicate Things

There’s little point in researching a fund unless you’ve already decided that the asset class represented by the fund is one that you want to include in your portfolio. And once you have decided which asset classes you want in your portfolio (and how you want to allocate between them), the portfolio almost builds itself–just keep costs low and keep things simple.

Mike’s note: I get a lot of questions from new investors. Often, the person is somewhat bewildered about investing in general and is having trouble figuring out where to start.

To that end, I invited my friend Matt–who was in a similar position just a few years ago–to share some of the questions he had when he was new, as well as the answers that he’s settled on as he’s gotten started investing.

Should I pay off debt or invest?

As a general rule of thumb, if the interest rate on your debt is higher than what you expect to earn by investing, pay off that debt as your first investment. Eliminating high-interest debt is a no-risk, high-return investment.

In fact, it might even be reasonable to work on wiping out all debt ASAP. For example, I consider myself to be particularly debt averse: I look at paying off debt as an investment in security. If I lose my income, the less debt I have, the less pressure I’m under. I’m willing to accept somewhat lower returns in exchange for that security.

Should I contribute to my 401(k) while in debt?

Contributing toward your employer-matched retirement plan is a special circumstance when it comes to investing. Think about it this way: If someone approached you on the street and offered to match the dollar amount currently in your wallet if you promise to save it, would you let them do it or would you tell them you can’t because that money is going toward debt?

It’s good to pay yourself first, but it’s even better to let others pay you first.

After you’ve contributed enough to get the maximum employer match, then go ahead and use any surplus to get out of debt. (Paying off debts in order from highest to lowest interest rate.)

Should I buy individual stocks?

Investing in individual stocks is tempting. There’s the possibility of striking it rich–a possibility that just doesn’t exist with broadly diversified index funds.

Still, I’ve chosen to build my portfolio using index funds and ETFs. Two good reasons for choosing index funds and ETFs over individual stocks are:

• Easy diversification: Just a few funds gives me a diversified portfolio. With individual stocks, diversification requires many more holdings.
• Less work: There’s no need to watch for news about the companies I own.

But what about stock tips?

If the tip is legit, unless you’re a market insider, chances are pretty good that the info has already been exploited by the time it gets around to you. I advise leaving individual stock ownership to day traders and professionals and sticking to something simpler and easier to understand.

Should I buy bonds?

Given that stocks have historically earned higher returns than bonds, many new investors wonder whether it makes sense to hold any bonds at all. The answer: Yes. Bonds are more secure than stocks, and even a small amount can significantly reduce volatility in a stock-heavy portfolio.

Because I am 35 I hold a fairly aggressive portfolio: 80% stock index funds, 10% bond index funds, and 10% physical precious metals. For my bond position I’ve chosen to use a Treasury bond fund because Treasury bonds are very secure. Using a Total Market bond fund would also be a reasonable choice. Just understand that if you do that, you will be investing in some higher-risk bonds as well.

If you are closer to retirement or more risk averse, it’s probably wise to hold a greater percentage of bonds than the 10% position I presently hold.

Should I buy precious metals?

Precious metals look quite appealing given the returns they’ve earned over the last couple years. But past isn’t always prologue when it comes to investing.

That said, I do actually hold physical silver with a small portion of my portfolio. But it’s not because I’m hoping to get lucky with amazing returns. Rather, I own silver as a sort of insurance policy against a collapse scenario for our debt-based fiat currencies. I prefer physical silver to precious metal ETFs or gold, neither of which would be as useful in such a scenario.

In closing…

If there is something I missed–and I’m sure there is–leave your question in the comments. I’ll answer to the best of my ability.

Matt Jabs set out on a passionate adventure to get out of debt back in January of 2009. He writes about personal finance at DebtFreeAdventure.com and about healthy self-reliance at diyNatural.com. Subscribe to his blog here.

I recently received this question from a reader:

“I’m about to get started investing, and I’m trying to figure out where to open my first Roth IRA. I know that you like Vanguard, but I don’t have the $3,000 that it takes to invest in any of their funds. What’s your suggestion for a new investor?”

My answer: It depends. Specifically, it depends on how much money you do have. But first, we need to back up a step.

Do You Have an Emergency Fund?

For most investors, building an “emergency fund” is a higher priority than saving for retirement. Unexpected expenses (car repairs, medical expenses, etc.) come along often enough that it’s important to plan for them. You don’t want to end up in debt just because you were eager to get started investing and your investments declined in value right before you needed to access them.

So if the cash in question is nearly all of your money, keep it in something safe (a savings or money market account, for instance), and continue working on saving. Eventually, you’ll get to the point where you can invest while still maintaining an emergency fund.

$1,000-$3,000: Vanguard STAR Fund

For investors with between $1,000 and $3,000 (outside of their emergency fund), I’d usually suggest opening an IRA at Vanguard and investing in the STAR Fund. Unlike other Vanguard funds, the STAR fund’s minimum investment is $1,000 rather than $3,000.

With a 0.34% expense ratio, it’s slightly more expensive than a low-cost index fund. But with $2,000 in the STAR fund, you’re still only paying $6.80 per year in expenses–hardly a catastrophe for your long-term investment success. And if you keep socking money away, you’ll soon be able to move it over to your favorite index fund(s) of choice.

Note: If you expect to spend the money within the next few years (on a first-time home purchase, for instance), the STAR fund’s ~62% stock allocation is too risky. CDs would likely be more appropriate. (Many brokerages and banks offer CDs inside an IRA account.)

$0-$1,000: Savings or Money Market

For new investors who haven’t yet managed to come up with the $1,000 necessary for the STAR fund, I would usually suggest just sticking with a plain-old savings or money market account–for now, anyway.

The first step to becoming a successful investor is to be a successful saver. So focus on saving until you’ve got it down to a science. If you can save just $20 each week, in less than a year you’ll have that $1,000.

(Just to be clear for any new readers: Vanguard is not the only good place to invest. There are plenty of other brokerage firms where you can build a low-cost diversified portfolio using index funds or ETFs. I’m just particularly keen on Vanguard because of their unique ownership structure.)

My wife writes a food blog.* For years, she used a simple “point & shoot” digital camera for all the photos. But as she learned more about photography, she realized that she would have to upgrade her camera in order to reach the level of photo quality to which she aspired.

While we were researching the purchase, I visited the Digital-Photography-School forums to ask the experts for their input. Before I knew it, I was looking at a $2,400 camera, a $380 lens, and a few hundred dollars of accompanying gear.

I had a similar experience shopping for a new laptop early last year. Any new computer would have beaten the pants off our 2004 vintage MacBook, but after reading several articles and reviews, I found myself leaning toward a rather high-end machine.

In both cases, I found that it was helpful to take a step back and think about our needs. After all, a feature that someone else considers an absolute necessity might end up going entirely unnoticed in our hands.

What This Has to Do with Investing

When researching a purchase–especially in a field in which you’re not an expert–it’s easy to get overwhelmed or talked into something you don’t really need.

The same thing goes for building a portfolio. While researching the decision, you’re going to get a whole list of varying suggestions, even from those of us who agree that a low-cost, passively managed portfolio is the way to go. For example:

• Some people will say it’s important to rebalance annually. Others will say every 2 years. Others will say to do it every time your asset allocation is out of whack by a specific percentage.
• Some people will insist that you’re better off if you overweight small-cap stocks and/or value stocks.
• Some people will insist that you need to have a certain portion of your portfolio in emerging markets, REITs, gold, commodities, or any of 100 other things.
• Some people will insist that you need to include corporate bonds in your portfolio. Others will argue that it’s better to stick to Treasuries.

The result I see over and over is that an investor will end up with a portfolio that has so many moving parts he/she isn’t entirely sure how to operate it. That is, a portfolio that made perfect sense in the hands of the person recommending it (an investing aficionado) ends up being a poor fit for the person who’s new to the field or who simply takes less interest in managing his/her portfolio.

Simplifying Your Portfolio

My advice is to simplify your portfolio until it reaches the point where you understand all your holdings, why they’re in your portfolio, and how/when you’re supposed to move money between them. If that means using ten funds, super. If it means using just two or three funds (or even just one), that’s perfectly fine too.

*Shameless plug: She writes at Wheat Free Meat Free, where she shares gluten-free vegetarian recipes.