I write a lot about how index funds are great tools for constructing a portfolio. Interestingly, one of the most common objections I hear against index funds is, “I don’t want to invest in the stock market.”
I’m not sure where the idea that index funds only own stocks came from, but it’s complete nonsense. There are numerous bond index funds, and they come in a wide variety of flavors–investment-grade corporate bonds, short-term Treasury bonds, mortgage-backed bonds, and so on.
An all-index-fund portfolio could just as easily be 100% bonds as 100% stocks. And the benefits of index funds (low-costs and diversification within the asset class in question) are just as important with bonds as they are for stocks.
Diversification Is Important for Bonds
In much the same way that it’s beneficial to diversify your stock holdings across numerous companies, it’s beneficial to diversify your bond holdings across numerous borrowers. With corporate bonds, it’s best to own bonds from a variety of companies in a variety of industries. And with municipal bonds, it’s best to own bonds from a variety of states/cities from around the country.
Noteworthy exception #1: There’s no need to diversify among different Treasury bonds. It’s perfectly OK to pick the most appropriate maturity for your purposes and stick with that.
Noteworthy exception #2: If you’re a muni bond investor who lives in a state that exempts in-state muni bonds from state income taxes, it likely makes sense to sacrifice some degree of diversification by overweighting in-state bonds in your asset allocation.
Costs Matter with Bond Funds Too
As important as it is to keep costs low when investing in stocks, it’s even more important when investing in bonds. The expected return of bonds is lower than that of stocks, so every tenth of a percent that goes to pay the fund manager takes a proportionally larger bite out of your final returns.
Unsurprisingly, if you browse the history of Standard & Poors Indices vs. Active Scorecards, you can see that actively managed bond funds have an even lower chance of outperforming their benchmark than actively managed stock funds do. (And that’s saying something!)
Diversifying Your Index Fund Portfolio
When financial advisors or writers suggest owning index funds, it’s unlikely that they’re recommending an index fund portfolio consisting exclusively of stocks. While stock index funds do provide a great deal of diversification across companies, it’s still important to include other asset classes.
Fortunately, the principles of keeping costs low and diversifying apply just as well to bonds as they do to stocks.