External Link Primark Datastream: very useful free charts of benchmark bonds for all major countries, from this well known market data provider,updated daily.

The most commonly used diversification strategy is to purchase securities with a range of maturities, a technique called LADDERING. This is done in order to optimise the risk:return ratio by reducing a portfolio's sensitivity to interest rate changes. A typical ladder would, for example, be created by investing equal amounts in securities maturing in two, four, six, eight and 10 years. Every two years, as a tranch of bonds matures the proceeds are rolled over and reinvested in ten-year instruments, maintaining the same ladder structure.

A ladder like this is a passive strategy, and for an actively managed private portfolio laddering has the disadvantage that it can be too complicated and costly--due to brokerage fees--to manage efficiently. For the better returns that I hope to achieve by actively managing a portfolio I prefer a different diversification technique: the BARBELL.

A barbell offers a similar degree of risk:reward optimisation as a ladder, also through the use of securities of different maturities, but in this case holdings are concentrated only at each end of the time spectrum. I like constructing a portfolio entirely of very short-term issues (up to 18 months), and long-terms (over 20 years). At the long end I believe that opting for zero coupon issues is usually best because they offer true compounding with the prospect of high capital gains: the interest rate risk of the portfolio is adjusted through the percentage of the portfolio invested at each end of the barbell (I am of course thinking here of a portfolio aimed at capital appreciation rather than for income). This strategy offers simplicity along with tremendous flexibility yet minimum trading costs. Once purchased, the long issues can remain in the long end of the barbell for a decade or more if necessary, or, as appropriate, can be sold in order to crystallise capital gains in the form of cash or safer short-term issues. And, by restricting the other end to only the shortest maturities there is almost never any need to incur fees or take a loss by selling a bond before maturity: as each one matures the proceeds can either be rolled over into another short term; used to buy a long dated issue at those times when it makes sense to shift the balance of the portfolio towards the long end; or turned into cash for the purchase of assets--I would expect to do that during the fire sale conditions likely during a post-crash business slump.

Another advantage conferred by the simplicity of the barbel is that it makes it less complicated to design a strategy that includes some foreign currency diversification within a private portfolio of moderate size. I believe that currency diversification is important: restricting yourself to your own currency may be dangerous to your wealth these days. The volatility that I have predicted is now looking like more of a mainstream view in the wake of recent dollar weakness.

Managed funds vs. going it alone

Professional management can have merit when it comes to the complex world of corporate bonds, but it is expensive and is of dubious benefit for portfolios consisting of high grade government and top-rated corporate issues. The way that funds are put together means that most of the advantages of bonds, and all of those that appeal to the conservative investor, are lost. For a smallish portfolio, a bond fund will admittedly be the only way to achieve broad diversification, but the disadvantages that I list below are not diminished and investors with limited funds ought to consider these disadvantages carefully before buying into a bond fund: purchasing a small number of short maturity government bonds might be a better option than a fund for many individuals.

Provided that you stick to top rated issues and take the trouble to learn the basics of bond investing--the relationship between price and yield, the risk rating systems, the meaning of strips (zeros) and their advantages, etc.--selecting and purchasing bonds is not difficult. There is a lot of information freely available. So why pay the significant fees and costs of professional management for something that you can do yourself, especially now that these are so high relative to current low yields. The fancy-sounding mathematical risk optimising formulae used by the funds are . . . well, remember Long Term Capital Management?

Another problem with funds besides costs is that they may be increasing your risk. Here is how. Unless you are a totally passive investor--and the fact that you are reading The Skeptical InvestorTM suggests that you are not--then you are making active decisions on your portfolio investment strategy such as timing and asset allocation. Lets say your chance of "getting it right" when deciding on bond fund purchases/sales is 50% (a bit pessimistic, I know . . . but lets use it just for the sake of argument). Now the fund manager is following an active strategy too. Lets say that his chance of "getting it right" is also 50% (optimistic or pessimistic? You decide). The probability of the "right" outcome is 0.5 times 0.5 = 0.25 i.e. a 1 in 4 probability. That is a gross oversimplification of what in reality is a complex series of individual decisions and outcomes, each with its own probability, but it illustrates the statistical principle: risks are multiplicative.

And with a pooled investment any partial redemption means taking a loss whenever it has to be made at an inopportune time: the investor has given up the flexibility of choosing which holdings to liquidate.

Finally, here is a good website that offers a basic introduction to bonds and offers a view of the markets that closely mirrors my own ("Caution is our hallmark"). Kauders is a British firm, so naturally the emphasis is on UK Gilts, but they are also keen on US Treasuries. Download a copy of their Learner's Guide to Capital Markets:-

External Link Kauders Portfolio Management.