Dear Dagen: How Can You Recommend Bonds to a 5-Year Investor?

It may be hard to recall now, but bonds have outperformed U.S. stocks over some five-year periods.
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In light of recent trends (the last five, 10, 15, 20 years) and market performance, how can you recommend bonds when the money isn't needed for five years? I have read that stocks outperform every other investment over a period of time. Are there any statistics that show bonds outperforming equities over any five-year period in recent history? -- Dan Pattee

Dan,

Many professionals caution investors who have only a five-year investment horizon to stay out of the stock market. I have repeated this incantation numerous times, including in a

column last week responding to a reader who asked where to stash his money until he's ready to buy a vacation home. But I have never bothered to explain why this is.

It is not about how much money you can make. It's about how much money you can lose. If you are planning to use your invested assets to buy that much-desired second home within five years, you don't want to risk losing any of that money. Right? Otherwise you might wind up spending vacations in your mother-in-law's Miami condo.

"I think it is pretty straightforward," says Andrew Lo, a professor at the

MIT Sloan School of Management

and director of the

Laboratory for Financial Engineering

. In the very volatile stock market, "you can lose pretty quickly."

Yes, the current bull market for stocks began back in 1982. But what can happen in five years or less is altogether different. (Just look at October 1987 or October 1997.)

A stock can plunge 20% in a day, but if you hold on to that stock for 10 years, the impact might be small or inconsequential. Short-term movements or noise, whether over a day, week, month or year, can hammer your portfolio. And, again, you want to be invested for long enough that your portfolio has the opportunity to recover from any loss like this.

You also could experience a damaging loss if you bought at the wrong time and sold at the wrong time, part of which stems from human behavior. What if you bought in just before the big selloff last year? Your stocks are diving, and you can only think about the money you are losing. Selling out at that moment is exactly the wrong thing to do, but it is very human reaction.

"If the market drops, the natural inclination is to pull it out," says Lo, co-author of the book

A Non-Random Walk Down Wall Street

. "That can be very dangerous." Basically, you not only have to contend with the performance of the market, you have to battle yourself.

Getting back to your question, there are, indeed, five-year periods when U.S. stocks aren't the dominant asset class. "It is true that stocks are expected to outperform over the long term," says Jeff Schwartz, senior consultant at

Ibbotson Associates

. But "we are talking 10 to 20 years."

Examining five-year rolling periods for a few different asset classes, "you will see at different times the highest-returning asset class hasn't been U.S. stocks," says Schwartz. It is "incredibly difficult to time the market and know what the best-performing asset class will be during that five-year rolling period."

For example, the

S&P 500's

compound annual return for the five-year period ended December 1977 was negative 0.2%, while the return for the 30-day Treasury bill was 6.2%, according to Ibbotson. For the five years ended December 1985, U.S. intermediate-term government securities beat the S&P 500, 15.8% to 14.7%. And there are other asset classes to take into consideration, such as foreign stocks or small-cap stocks, which have experienced their own periods of outperformance.

Of course, large-cap U.S. stocks have looked awfully good over the past decade or more, but there is no way for you to know which asset class will make or lose money in the near term.

Ibbotson doesn't rule out using equities for someone with five years or less to invest, but he recommends limited use of stocks as part of a diversified portfolio. "By adding equity, one can actually reduce the potential volatility and hopefully get higher returns," says Schwartz. For a one- to five-year time horizon, Ibbotson suggests an investor hold somewhere between 10% to 40% in equities in a well-diversified portfolio that would include foreign and small-cap stocks and bonds of different maturities. "We are very concerned that a person's time horizon will allow

the investor to recoup a significant short-term loss," Schwartz adds.

Other professionals may be more cautious when it comes to shorter-term investments. Lo tells his friends and family, "The kind of money you want to put in the stock market is your Mad money." That's the kind that you aren't worried about losing.

Send your questions and comments, along with your full name, to

deardagen@thestreet.com.

Dear Dagen aims to provide general fund information. Under no circumstances does the information in this column represent a recommendation to buy or sell funds or other securities.