Barry's Not the Only Bonds Posting Big Numbers

Bond funds have outperformed stock funds over three years, the first such stretch in more than a decade.
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The tortoise has found his way into the winner's circle, illustrating why it's always good to spread your bets.

Despite stocks' meteoric rise in 1998 and 1999, hum-drum bonds have actually beaten stocks over the past three years. The

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Vanguard Total Bond Market Index fund, which tracks the Lehman Brothers Aggregate Bond Index, is averaging a 6.9% annual gain over that stretch, compared to a 3.8% rise for the

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Vanguard 500 Index fund, which tracks the S&P 500.

This rare event points out how poorly shares -- particularly the tech issues that were hogging investors' money and attention -- have performed since the

Nasdaq

peaked in the spring of 2000. The unusual divergence also shows why it's a good idea to spread your money broadly among stocks and bonds, allowing you to keep your shirt on as the market moves through its unpredictable cycles.

"This shows that diversification makes a lot of sense," says Scott Cooley, a senior fund analyst with Chicago fund tracker Morningstar. "It made the most sense over the past two years when people were least willing to do it."

It's easy to see why investors have traditionally had no appetite for bonds. Since the 1920s stocks have averaged about an 11% annual gain, while long-term corporate bonds have chugged north at a 6% clip. If you compare three-year returns ending in December over the past 20 years, bonds beat stocks only twice -- and narrowly at that, in the three-year periods that ended in December 1983 and 1984.

Following that template, the first six months of 2000 saw redemptions from bond funds

outpace investments by $40 billion. But in the same period this year, bonds are in the black by $38 billion, according to New York fund consultancy Strategic Insight.

The list of tech stocks and growth funds trailing the Vanguard bond fund over the past three years is littered with high-powered names. Widely held favorites like PC makers

Compaq

and

Dell

, as well as networking titan

Cisco

and software giant

Microsoft

, have been left in the dust. These were the very stocks many fund managers thought would be core holdings for years.

It's probably no surprise, then, that many of the growth funds that rode big-cap tech stocks to big gains in 1999 are also lagging behind bonds now. A look at the bestselling funds of 1999 and 2000 turns up several that are trailing the Vanguard Bond fund. Fallen faves like the

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Fidelity Aggressive Growth,

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Munder NetNet and

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Janus Twenty funds are all averaging losses over the past three years.

In addition, the nation's two largest stock funds,

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Fidelity Magellan and Vanguard 500 Index, have underperformed Vanguard's now popular bond fund. More than $160 billion resides in those two stock funds, compared to some $14 billion in the bond fund.

Of course, stocks have still done better over the long haul. Even including last year, when the bond fund rose 11.6% and the S&P gave back 9.1%, the return picture returns to normal if we look a bit further back: Over the past decade the Vanguard 500 fund's 14.4% annualized gain easily bests the Vanguard Total Bond Market Index fund's 7.9% average annual return.

So the next logical step isn't to put all your money in bonds or to bet the farm on stocks, figuring they're due to end their funk. Instead, check out our take on how you can use

bond funds and

value funds to smooth out the performance of a tech-sick portfolio. If you decide to go that route, we've also pulled together a short list of solid

bond and

value funds that are worth a look.

In any event, it's never been more clear that there's a world beyond big-cap tech and growth, though that was far from obvious to some not too long ago.

Ian McDonald writes daily for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He invites you to send your feedback to

imcdonald@thestreet.com, but he cannot give specific financial advice.