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“Reaching for yield” is the process of buying higher-risk income securities when lower-risk securities just don’t pay enough for your liking. It is one of the classic mistakes, made by novice and professional investors alike, that can lead to paralyzing losses.

Individual investors have been pouring billions of dollars into bond funds in the wake of the financial crisis that evidently created a strong aversion to stocks. I’ve written that I think this is probably another case of individual investors managing to buy precisely the wrong thing at precisely the wrong time.

The fact that professional investors are now “reaching for yield” in desperately trying to justify their fees tells me I may be onto something. The Wall Street Journal Reports:

Bond funds are the most popular category of mutual funds, attracting net inflows of $204 billion so far this year through Aug. 31, compared with net outflows of $59 billion in U.S. stock funds during the same time period, according to investment-research firm Morningstar. At the same time, bond funds’ “tracking error,” the term Morningstar uses to describe a fund’s divergence from its benchmark, has increased. Through Aug. 31, bond funds have posted an average tracking error of 2.196% for the year, compared with 1.951% during the same period in 2011, according to a Morningstar analysis. A reading of zero signifies perfect alignment with the benchmark, although that is rare. During that same period, bond funds beat their benchmarks by an average of about 1 percentage point, after having lagged behind by about half a point during the same time period in 2011, according to Morningstar.

What bond investors need to know is that this performance cuts both ways. Outperformance on the upside today will mean underperformance on the downside later as overly aggressive funds pay the price for their lack of prudence.

For their investors this means that a crash in the bond market would be that much more painful than if their fund had not strayed so far from its benchmark. Bottom line: it’s a good time to take a look at what you really own (and if it’s a fund, what they own) so that you are keenly aware of the risk.

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