In my experience, when one asset class begins to enjoy increased popularity at the expense of others, it’s time to take some chips off the table. That is the case with equities; after a rapturous July that saw stock indexes hit multiyear highs, irrational exuberance is beginning to creep into the markets. Diversifying investments, particularly into fixed income, should not be ignored.

To be sure, there are all sorts of reasons why bonds’ luster has dimmed compared to stocks. Rising short-term interest rates, a much-better-than-expected earnings season, and the putrid performance of the fixed-income sector in July are but three reasons to loathe them. However, I think there are some compelling reasons to maintain a modest portion of bonds in a diversified portfolio as the summer comes to a close.

First off, bonds are a great hedge against rising oil prices. This may sound counterintuitive, but investors should consider every rally in crude prices as leading eventually to reduced economic activity. Fixed income would be an obvious beneficiary to any slowdown, since the Fed would likely be forced to stop raising rates.

The potential risk of another terrorist attack should also compel investors to hold some bonds. In a flight-to-quality scenario, fixed-income investments tend to rally. It won’t keep a mostly stock portfolio in the green during such a daunting period, but it should at least mute the pain.

Finally, and perhaps most obviously, bonds are great diversifiers for stocks. In periods when stock price momentum evaporates, fixed income investments have proven their mettle by both reducing portfolio volatility and increasing returns.

Index Jul-05 QTD YTD Description
S&P 500 Index* 3.60% 3.60% 1.84% Large-cap stocks
DJIA* 3.56% 3.56% -1.32% Large-cap stocks
Nasdaq Comp.* 6.22% 6.22% 0.43% Large-cap tech stocks
Russell 1000 Growth 4.89% 4.89% 3.08% Large-cap growth stocks
Russell 1000 Value 2.89% 2.89% 4.71% Large-cap value stocks
Russell 2000 Growth 6.99% 6.99% 3.16% Small-cap growth stocks
Russell 2000 Value 5.69% 5.69% 6.64% Small-cap value stocks
EAFE 3.70% 3.70% 2.20% Europe, Australasia & Far East Index
Lehman Aggregate -0.91% -0.91% 1.58% U.S. Government Bonds
Lehman High Yield 1.75% 1.75% 2.88% High Yield Corporate Bonds
Calyon Financial Barclay Index** -0.20% -0.20% -0.20% Managed Futures
3-month Treasury Bill 1.51%
All returns are estimates as of July 31, 2005. *Return numbers do not include dividends. ** Returns are estimates as of July 28, 2005