This year is on pace to be the worst in history for the standard 401k investment strategy. A balanced portfolio of stock and bond index funds has performed terribly in 2022. Workers who get their third-quarter 401k statements will be shocked.

Today, let’s discuss why this happened and how to do better…

The traditional 60/40 portfolio has 60% in stock index funds and 40% in bond index funds. The bond funds are supposed to be less volatile and make up for some of the stock market losses during bear markets. But that strategy hasn’t worked out this year: so far in 2022, stocks are down 23%, the iShares 7-10 Treasury Bond ETF (IEF) is down 17%, and investment-grade corporate bonds have fallen by 22%.

Put these negative returns together, and never in history has a traditional stock and bond balanced portfolio lost so much money. Most of us understand that stocks go through bull markets and bear markets. What’s harder to grasp is how investment grade and Treasury bonds can lose 20% of their value.

Bonds are interest-paying instruments that pay off a face value when they mature. The expected return should be the yield to maturity in effect when a bond is purchased. The problem comes from how bonds were viewed through 30 years of falling interest rates.

Bond prices move inversely to interest rates. This relationship means when rates are falling, bond prices are supposed to go up. The long period of falling interest rates trained money managers to count on capital gains from bond funds in addition to interest income. As interest rates moved close to zero, financial advisors continued to depend on bond price appreciation from the recommended bond funds.

A return to rising, and quickly rising, interest rates blew up bond fund investing. It’s a direct, mathematical correlation between bond fund prices and interest rates. Since bond funds don’t hold bonds to maturity, bond fund share prices go down and stay down when interest rates go up.

Bond fund prices are different from stock prices. Share prices can and do recover from a market decline. Bond fund share prices will only go up if interest rates fall, and the nature of bond funds (vs. owning bonds directly) makes recovery much less than the magnitude of the decline. And that’s assuming interest rates go down.

I hope you get the idea that index-tracking bond funds are not good for your wealth or your 401k account value. That said, now that interest rates have gone up, investing in fixed income securities makes sense in a balanced portfolio. You want to invest in securities with a fixed maturity that will pay a face value when they mature. Here are a few ideas…

Buy individual bonds. You can easily buy Treasury Bills and Notes through your brokerage account. Six-month T-bills yield above 4.3%, and these bonds are very liquid. Talk to your broker about municipal bonds if you are in a high tax bracket.

Certificates of Deposit (CDs) pay similar yields. You will likely find better CD rates through your stockbroker than from your local bank.

Series I Savings Bonds pay based on the rate of inflation and currently yield close to 10%. I Bonds have some limits and restrictions, but if you have some cash to sock away, the yield is fantastic.

The Invesco BulletShares series of bond ETFs solves the bond fund problem. Each of these ETFs own bonds that mature in a specific year. These funds allow investors to set up an old-fashioned bond ladder, an excellent tactic to maximize investment income and liquidity.

In my Dividend Hunter service, I have provided in-depth information on the BulletShares features and how to use them in a portfolio. See below for how to join.

— Tim Plaehn

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Source: Investors Alley