The Trust-No-One Investing Plan

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It's only when the rinse cycle begins," a wise old friend of mine likes to say, "that you can tell how dirty the laundry really was." With Enron, Arthur Andersen, Henry Blodget and Dennis Kozlowski all sloshing back and forth in the muck, it has become clear to everyone that the late bull market in stocks was fueled partly with Potemkin profits, partly with bluster, partly with outright lies.

Yet I don't think you should get out of stocks; when the market puts shares on the bargain counter, logic dictates that you should buy, not sell. On the other hand, this is an ideal time to make sure your portfolio is protected against the next Enrons and Tycos.

That's what bonds are for. Unlike stocks, which are primarily a bet on tomorrow's growth, bonds provide a stream of income today and tomorrow. As its name implies, a bond is also a kind of contract that commits the borrower to give you all your money back down the road. So bonds, unlike stocks, almost never go to zero, making them the ultimate trust-no-one investment. What's more, they can provide ballast for a sinking stock portfolio. "Bonds have actually outperformed stocks over the last five years," points out portfolio manager Ian McKinnon of the Vanguard Group. While stocks have gained 6.1% annually over that period (and lost a ton lately), bonds have earned better than 7% per year.

Interest rates may look like chicken feed right now--but inflation is low too, so your real return is richer than it looks. Even when bonds yielded 8% in the early 1990s, their return after inflation was under the 3.2% you can net on today's 4.8% bonds (see chart). That's why you shouldn't join the herd of investors stampeding into high-yield--or junk-bond--funds; so far this year, the public has poured $9 billion into these buckets of risky corporate debt, nearly half as much as the money attracted by all stock funds combined last year. And I wouldn't get within spitting distance of loan-participation funds like Van Kampen Prime Rate Income Trust, which hold business loans made by banks. These funds typically charge big fees while allowing you to sell your shares a measly four times a year. What good is a slightly higher yield if you can't get your money out when you need it?

Instead, consider TIPS, or inflation-protected Treasury bonds. Uncle Sam isn't going to default on his debt (or, if he does, the world economy will be such a mess that nothing else will be worth investing in either). And TIPS guarantee you can't lose money after inflation. They're no longer cheap but still yield up to 3.1 percentage points over the current inflation rate. Put them in your IRA or other retirement account, where their quirky tax features won't "drive you stark raving mad," as Loomis Sayles Bond Fund manager Daniel Fuss puts it. You can buy tips directly from the government, at www.publicdebt.treas.gov/sec/seciis.htm or in a fund from Vanguard or Pimco.

In a taxable account, municipal bonds look good right now, says Vanguard's McKinnon. Low-cost muni funds are available from Vanguard, as well as from Fidelity, T. Rowe Price and USAA, with yields of 3% to 4%, tax free. McKinnon also likes REIT funds, which invest not in bonds but in the income-rich shares of real estate investment trusts. Vanguard's REIT fund yielded 5.3% last year; another economical choice, Cohen & Steers Realty Shares, yields 5.1%.