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R. Scott Maxwell, MBA

You thought you were safe.

In fact, you specifically wanted to avoid the volatility of the stock market. You put your money in carefully selected bond funds with multi-star ratings. Each of the funds you picked exceeded the Lipper averages for their category and had a history of very strong cash yields. It looked and felt like the best of both worlds - you were protected from the risks of the stock market and you would receive a nice income from the bond funds.

And then 2008 came along and ruined your plan.

You are not alone, and the losses were very unpleasant.

Investment News reported a staggering 19 of the 25 largest fund companies ranked by average asset-weighted taxable-bond returns had negative returns as of September 30, 2008.

The Barclays Capital US Credit Long Index (composed of all publicly issued, fixed-rate, nonconvertible, investment-grade corporate debt rated at least Baa by Moody’s Investors Service) was down 18.8% as of November 30, 2008 - its worst annual return since 1973.

Higher risk bond fund owners suffered almost the same pain as their stock fund owning brethren. The Merrill Lynch US High Yield Master II bond index (a measure of the broad high yield corporate bond market) was down 26.39% in 2008.

Morningstar’s broad corporate bond index was a less painful, yet it was still down 3.07 for 2008.

It only takes a minute to review your year-end statement and determine if your bond fund failed to provide the “safe haven” you expected it to offer.

Weston Wellington, Vice President of Dimensional Fund Advisors, nicely sums up a problem many investors encountered in 2008, “Many fixed income strategies have delivered unexpectedly large losses just when their contribution as a risk reducer was needed most.”

So, what happened? Is this something new? Did all bond funds fail to deliver in 2008?

No, this is not new. And no, not all bond funds were creamed in 2008.

The problem is not bonds or fixed income as a category, but rather found in the way many investors view and use fixed income funds.

Typically, investors make the mistake of trying to maximize yields and seek fixed income bond funds with exceptional short-term performance. They somehow forget the bedrock market relationship between risk and reward and assume today’s best performing fixed income funds will continue to perform well in all market conditions. 2008 exposed the flaws in this line of reasoning.

Fundamentally, the best use of fixed income within a portfolio is to reduce portfolio risk. Stocks are volatile and that volatility is the reason they offer the potential for higher returns over the long-run. Bond funds can offer strong returns in certain market conditions; however stocks offer historically better performance than bonds within similar risk profiles. Why put your money at risk in a bond fund that has historically underperformed a similarly volatile stock fund?

Fixed income, when used properly, provides balance to a portfolio’s volatility in keeping with an investor’s personal comfort zone, their return objectives and their time horizon.

So, what type of fixed income will get you where you want to go?

We believe in high quality, short duration and globally diversified bond funds. Our favorites are the 2-year and 5-year Global Bond funds from Dimensional Fund Advisors.

Why? Because they seek to manage two primary risks associated with fixed income - term risk and credit risk.

Term risk - the risk associated with long-term bonds fluctuating in price due to interest rate changes - is the price investors must pay to receive the higher yields typically offered by long-term bond funds. High yields look good on paper but often are not enough to overcome losses incurred when a volatile long-term fund loses value as interest rates decline. DFA’s 2-year and 5-year funds offer the proper balance between the risk and rewards of bond maturity schedules.

Credit risk - the risk associated with the company or organization issuing the bonds - is the main focus of most fixed income funds and the cause of much of the poor showing of those funds in 2008. Companies and organizations with lower credit ratings must offer higher yielding bonds in order to attract investor capital. Fixed income fund managers do their best to balance the credit risk vs. reward profile of their funds in an attempt to maximize yields and returns. The strategy works great in an up market. I don’t need to remind any of you that 2008 was not an up year.

Global diversification (while appropriately managing foreign currency risks) is an added feature designed to provide even more stability to your fixed income strategy. Just as the long-term benefits of owning a diversified fixed income fund outweigh the risks of owning individual bonds, we diversify away country specific risks by owning a portion of the global bond market.

You have a choice.

You can continue to pursue the return chasing, market timing, stock or fund picking strategies that got you where you are today. You may have the hot hand at the table in 2009. But then again, the house usually wins.

Or, you can embrace an investment philosophy that puts substance ahead of style, focuses on the long-term and is purposely built to your unique needs and objectives so you never need to worry about your investments again - the very definition of Peaceful Wealth.