- Bonds offer better yields than bank accounts, but the risks associated with a well-diversified bond portfolio are minimal.
- Bonds, in general, and government bonds in particular, help stock portfolios diversify and prevent losses.
- Bond ETFs make it simple for investors to benefit from the advantages of a bond portfolio.
What is the purpose of bonds?
- They give a steady stream of money. Bonds typically pay interest twice a year.
- Bondholders receive their entire investment back if the bonds are held to maturity, therefore bonds are a good way to save money while investing.
Companies, governments, and municipalities issue bonds to raise funds for a variety of purposes, including:
- Investing in capital projects such as schools, roadways, hospitals, and other infrastructure
Is it true that stocks are riskier than bonds?
Stocks are typically thought to be riskier than bonds. This article presents the statistics in a graphical format so that you can see for yourself whether stocks are indeed riskier than bonds.
Stocks are undoubtedly riskier than bonds for short-term investors. However, data from actual historical returns reveals that bonds were actually riskier than stocks for long-term investors. But it all hinges on having a clear understanding of what risk is.
Almost the entire investment community is focused on the erroneous notion of risk when it comes to long-term investors. For a long-term investor, much of what is written about risk is at best irrelevant and at worst simply incorrect. This is the result of a focus on short-term volatility.
We need a precise definition of risk for long-term investors. Risk is defined by financial academics and the investment community as the short-term (annual, monthly, or daily) volatility of an investment’s returns. The variance or standard deviation of returns is a measure of their volatility.
This notion of risk is problematic from the standpoint of a long-term investor for two reasons:
- The volatility of annual (or even monthly or daily) returns is nearly often the emphasis of the investigation and conclusions. For many investors, a yearly focus is appropriate, but long-term investors should be more concerned with the risks connected with their long-term wealth level, rather than the bumps along the way.
- Almost all analyses and conclusions are predicated on nominal returns, ignoring inflation’s degradation of buying power. Inflation may not be a major concern for short-term investors, but it has a significant long-term impact.
In regards to the second point, it seems self-evident that real (inflation adjusted) returns will lead to more accurate conclusions than nominal returns.
As for the first point, stocks are significantly riskier than long-term bonds or Treasury bills under the short-term volatility definition of risk (T-Bills). Stocks have outperformed both 20-year government bonds and T-Bills across all but one historical calendar 30-year period, according to US statistics dating back to 1926. Except for one of the 67 different 30 calendar year combinations, “Stocks have delivered a greater return from 1926 to 1955, then 1927 to 1956, all the way up to the most recent period of 1992 to 2021. Stocks, on the other hand, are deemed riskier due to increased annual volatility! (Admittedly, there would be more 30-year periods where long term bonds outperformed stocks based on non-calendar year start and finish points.)
You may be recommended to place a significant amount of your investments into Bonds or T-Bills to prevent risk (defined as annual or daily volatility), even if historical data suggests that they are nearly certain to underperform equities in the long run. While this way of thinking about risk may help you sleep easier at night, it could be quite dangerous to your long-term prosperity. (That is, if your goal is to maximize wealth at a remote time in the future, such as 20 or 30 years from now, as many investors, particularly younger investors, do.)
From 1926 to the present, the following graph depicts the real annual volatility in stock, bond, and T-Bill returns. This discussion of stocks is limited to the performance of the S&P 500 major firm stocks as a whole; it does not address the hazards of investing in a non-diversified stock portfolio. The bonds are 20-year US government bonds, and the investment is rolled over each year into a new 20-year bond to maintain the 20-year maturity. The data shown here is for U.S. returns from the Ibbotson yearbook Stocks, Bonds, Bills, and Inflation. The data for 2021 is current as of November 4th and derived from different sources. The totals represent the results “Dividends and capital gains or losses are included in “real” returns, which are adjusted for inflation each year. (Real returns are adjusted upwards by deflation during the depression years.) “The “inflation” figure was negative.)
Because the data for 2021 is as of November 4, 2021, it is referred to as 2021e or 2021 approximated. By the end of 2021, the real outcomes will most likely be only slightly different.
On an annual basis, the stock returns (blue bars) were unquestionably more volatile. Returns on long-term Treasury bonds (red bars) were likewise extremely volatile, although T-Bill returns (green bars) were more consistent. It’s also clear that the average stock return is far higher than the average bond return, which is significantly higher than the average T-Bill return.
Stocks have recorded calendar year losses of above 30% on a real return basis in four of the 96 years from 1926 to 2021, the most recent being in 2008. And two of those occurrences (1930-1931 and 1973-1974) featured an adjacent calendar year with a loss of at least 20%, resulting in a total compounded loss of more than 60%! Using daily data, there would be more instances of equities falling by at least 60% from their prior high. That is a very real danger, and it is exceedingly difficult to bear. Despite this, we know that equities have consistently outperformed bonds over time.
The age-old debate for investors is whether the (very likely, but not guaranteed) higher long-term average return from equities deserves the additional risk (short-term volatility).
You must consider more than annual volatility when assessing the risk of stocks vs bonds. This is demonstrated in the following.
Imagine your wealthy uncle inviting you to a coin toss game. In the event that you lose, he will receive half of your net worth. If you win, he will pay you twice your current net worth.
So you’ll win 75% of your net worth on average, but you’ll also have a 50% chance of losing half your net worth and a 50% chance of tripling your net worth.
Is it worth your time to play this game? Yes, according to simple expected value math, but most people would consider it too hazardous to play. Losing half your net worth on a coin toss would be a tremendous bummer. (If a man is unsure, he should consult his wife; she will most likely have no reservations.)
How dangerous is this game? It’s really dangerous unless you’re permitted to play multiple times. Consider what would happen if your beginning net worth was $100,000 and your wealthy uncle told you that you could divide your money into ten piles and play the game ten times, with each attempt costing $10,000. If you win five times and lose five times, you will win $100,000 and lose $25,000, leaving you with a profit of $75,000. If you only win two times and lose eight, you’ll make a profit of $40,000 and a loss of $40,000 to break even. So now you can only lose if you win less than two out of ten coin tosses. This has a significant impact. It suddenly looks much more logical to play the game because there is so little risk of losing. Your predicted return remains at 75%, but your risk is significantly decreased (though not eliminated).
This demonstrates the importance of asking how many times you get to play the game when considering any risky undertaking. If the average return is positive, the risk decreases as the number of times you are permitted to play increases, and the risk approaches zero if you are allowed to play many times. The standard deviation of your overall return over “N” tries is calculated by multiplying the standard deviation of each individual try by the square root of “N.” As an example, “As “N” grows larger, your overall risk decreases dramatically.
Similarly, the longer you stay in the stock market, the less dangerous it becomes, if risk is defined as the chance of failing to beat bond or cash returns throughout your whole holding tenure.
When it comes to the stock market and the spectrum of possible returns, you can’t assess your risk without first considering how long you’ll be investing. It is widely assumed that the average investor is primarily concerned with annual and even daily returns, and has a one-year time horizon. The majority of stock market risk debate you’ll ever encounter will be on one-year or even daily volatility. That may be acceptable for the fictional average investor, but for actual long-term investors, it leads to entirely incorrect conclusions.
I would say that the danger of insufficient long-term real purchasing power growth is definitely the more significant risk for a long-term investment. When it comes to the long-term investor, analysis that focuses on the risk of short-term volatility in wealth or returns is simply looking at the incorrect risk.
You are under no obligation to agree with my opinions. You can also look at the graphs and come to your own conclusions.
Before acting, self-described long-term investors must ensure that they truly have a long time horizon. Many investors may find themselves in the position of having to pay out their investments early. This could be due to a variety of factors such as illness, job loss, disability, legal issues, and so on. However, if an investor is almost certain that they will have a very long time horizon, equities (based on a large stock index in the United States) look to be no riskier than bonds in terms of obtaining the highest end portfolio value.
The risk versus return trade-off, according to most investing theory, is a question of human preference. The stock market provides higher predicted average returns on equities, but at the cost of greater annual volatility. To their credit, the industry encourages investors with longer time horizons to have a bigger equity weighting, but it nevertheless recommends that all investors put some funds to bonds and bills. However, this provides investors with very little guidance.
In the end, I believe the risk-reward trade-off is more a function of time horizon and education than of personal taste. If you are almost positive that you will not need the money for another 20 years or more, stocks are not a riskier investment. Stocks will almost probably outperform bonds and bills in terms of returns (based on historic data).
If investors are informed about this, they can become more comfortable with stock volatility on a daily, monthly, and annual basis, knowing that they will virtually certainly achieve significant long-term returns. It’s like driving down a winding mountain road with a lot of switchbacks. Switchbacks and backtracking can be extremely stressful if you are unfamiliar with the road (as you think you are going in the wrong direction). However, if you have carefully studied a map, you may relax and the switchbacks will not upset you because you know the road to your destination will be winding.
Additionally, persons in the saving stage of their lives are not dependant on any one thirty-year period, but rather spend a set amount each year. Through time diversification, this lowers risk. If stocks are extremely likely to outperform bonds over a 30-year holding period, stocks may be nearly guaranteed to outperform bonds over a long sequence of 30-year holding periods.
Should I lower my bond holdings?
- Short- and medium-term bonds are less vulnerable to rate hikes than longer-maturity bonds, which lock in higher rates for longer periods of time. Short-term bonds, on the other hand, have a lower potential for producing revenue than longer-term bonds.
- When interest rates begin to climb, inflation-hedging investments perform poorly because higher rates reduce inflation.
- It’s a good idea to keep your fixed-income portfolio liquid, and it’s also a good idea to lock in your mortgage rate before it rises.
What are the dangers of bond investing?
- The risk of a bond’s value falling in the secondary market due to competition from newer bonds with better rates is known as interest rate risk.
- The danger that the bond’s cash flow will be reinvested in new issues with a lower return is known as reinvestment risk.
- If interest rates fall, the issuer may choose to shorten the term of a bond. This is known as call risk.
- The risk of the issuer failing to pay its financial obligations is known as default risk.
- The danger that inflation will destroy the value of a fixed-price bond issue is known as inflation risk.
What part of a portfolio do bonds play?
Bonds are regarded as a defensive asset class since they are less volatile than other asset classes like equities. Many investors use bonds as a source of diversification in their portfolios to assist minimize volatility and total portfolio risk.
Is bond investing a wise idea in 2021?
Because the Federal Reserve reduced interest rates in reaction to the 2020 economic crisis and the following recession, bond interest rates were extremely low in 2021. If investors expect interest rates will climb in the next several years, they may choose to invest in bonds with short maturities.
A two-year Treasury bill, for example, pays a set interest rate and returns the principle invested in two years. If interest rates rise in 2023, the investor could reinvest the principle in a higher-rate bond at that time. If the same investor bought a 10-year Treasury note in 2021 and interest rates rose in the following years, the investor would miss out on the higher interest rates since they would be trapped with the lower-rate Treasury note. Investors can always sell a Treasury bond before it matures; however, there may be a gain or loss, meaning you may not receive your entire initial investment back.
Also, think about your risk tolerance. Investors frequently purchase Treasury bonds, notes, and shorter-term Treasury bills for their safety. If you believe that the broader markets are too hazardous and that your goal is to safeguard your wealth, despite the current low interest rates, you can choose a Treasury security. Treasury yields have been declining for several months, as shown in the graph below.
Bond investments, despite their low returns, can provide stability in the face of a turbulent equity portfolio. Whether or not you should buy a Treasury security is primarily determined by your risk appetite, time horizon, and financial objectives. When deciding whether to buy a bond or other investments, please seek the advice of a financial counselor or financial planner.
Stocks or bonds have additional risk.
Each has its own set of risks and rewards. Stocks are often riskier than bonds due to the multiple reasons a company’s business can fail. However, with greater risk comes greater reward.
Are bonds or stocks a better investment?
Bonds are safer for a reason: you can expect a lower return on your money when you invest in them. Stocks, on the other hand, often mix some short-term uncertainty with the possibility of a higher return on your investment. Long-term government bonds have a return of 56%.