We’ve all heard it a thousand times--stocks are riskier than bonds. This mantra has prompted many young people to swear off stock investments in favor of “safer” bonds and even certificates of deposit. And the result is a far, far riskier approach to investing than they can possibly imagine.
Before we get into the details of the risks of stocks and bonds, let’s look at this issue from a different perspective. What’s your immediate answer to the following question--
"You need to travel from Washington, D.C. to California. Which is safer, driving or flying?"
If you are like most, your immediate thought went to which mode of transportation is least likely to kill you. Now let’s add one additional fact to the question: You need to make the trip in under seven hours. Now, which one is the safer bet? Depends on how you define “safe.”
There are a number of parallels between our travel question and investing. Most people think of investment risk as the chance that a given investment will lose value in the short term (the plane will crash). You can certainly reduce the risk of losing money in the short term; just put your money in an FDIC-insured savings account. But much like driving to California to play it “safe,” by doing so, you accept the substantial risk that you won’t meet your financial goals.
Here’s why. Many investors focus solely on investment risk (the risk that the price of an investment will fall below their purchase price) while completely ignoring purchasing power risk (the risk that your investment, even if it grows, will be worth less in the future once you take into account inflation). While the former should not be ignored (just ask former Enron stockholders), the latter can be just as dangerous to your investment plans. Moreover, the risk that a diversified portfolio will lose value diminishes over the long term.
Now let's look at the details.
When the "experts" tell us that stocks are riskier than bonds, they are referring to what is called beta. Beta is a measure of an investment's volatility. For example, a stock with a beta of 1 will have the same volatility of the market as a whole, while a stock with a beta of 0.5 will be half as volatile. A stock with a beta of 2 will be twice as volatile.
For you investing junkies, beta is calculated by dividing the covariance (the degree to which returns on two assets move together), of the daily percentage changes for the stock and the index by the variance (volatility from the average). Detailed instructions for calculating beta are here.
Generally speaking, stocks have a higher beta than bonds. That is to say, the price of stocks typically swings up and down to a greater degree than bonds. We see it every day when we watch the markets. There are some exceptions--junk bonds and emerging market bonds are subject to significant variability. But generally, the price of stocks varies more than the price of bonds.
But here’s the key--for long-term investors, this volatility should be the least of our concerns. Think back to 2008 when the market crashed. For long-term investors who won’t retire for decades, the events of 2008 are irrelevant. Think of 2008 as mild turbulence on your way to California.
So if beta isn't our chief concern, what is? I'm glad you asked.
Purchasing Power Risk
"The riskiness of an investment is not measured by beta but rather by the probability of that investment causing its owner a loss of purchasing power over his contemplated holding period. Assets can fluctuate greatly in price and not be risky as long as they are reasonably certain to deliver increased purchasing power over the holding period. And a nonfluctuating asset can be laden with risk."
-Warren Buffett (2012).
Purchasing power risk is the risk that inflation will erode the value of a portfolio over time. Over short time periods, even up to a year, the effect of inflation may seem small. Over decades of investing, inflation can decimate an investment portfolio. As a result, "safe" investments that can't deliver a return over and above inflation are, as Buffett described, "laden with risk."
The “non-fluctuating asset” Buffett refers to would include things like high-interest savings accounts. These FDIC-insured “investments” will never, ever lose money in absolute terms. At today’s rates, deposit $1,000 in a savings account paying 1% and you are guaranteed to have $1,010 12 months later. If inflation is 2%, however, the $1,010 12 months from now will buy you less than the $1,000 can today. That’s why Buffett says such investments are “laden with risk.” You’ve side-stepped beta, but you’ve locked in a guarantee that the purchasing power of your money will decline.
The point isn’t that you should have a savings account. They are great for emergency funds and short-term cash needs. But don’t think of them as part of a long-term investment strategy for your retirement.
There are two important reminders for investors. First, the effect of inflation is compounded over time. For example, the historical rate of inflation in the U.S. is about 3%. If your time horizon is measured in decades (this is the case for most investors saving for retirement), your purchasing power would be cut in half in 24 years if inflation continues to average 3%.
Second, in a lower return environment like the one we’ve seen over the past few years (and is predicted to continue due to the zero interest rate environment and the New Normal made famous by legendary bond investor Bill Gross of PIMCO), the effect of inflation is much more pronounced. For example, if you earn 15% and the inflation rate is 3% you still earn a net 12% and inflation only eroded 20% of your return. However, if you earn only 5% and the inflation rate is 3% you earn a net 2% and inflation eroded a whopping 60% of your return. And these returns are before taxes. Yikes!
Bonds Can Be Really Risky
Before bringing this article to a close, there's one more thing we need to cover about bonds. One of the main risks for bond investors is duration, or how much the price will move given a change in interest rates. Duration is measured in years (bonds can have durations ranging from a few months to 30 years or more).
For example, a bond with a 5-year duration will fall 5% in value if rates rise 1%. As a result, longer-duration bonds are riskier than shorter-duration ones in a rising rate environment. Today, there is a high probability that rates will rise and bring down bond values since interest rates can hardly get any lower.
While higher quality bonds such as U.S. Treasuries and high-grade corporate bonds will perform better than the emerging market or junk bonds when rates rise, they will still lose value. While investors are reaching for yield with rates so low, this is not without risk. Junk bonds lost 22.7% in the fourth quarter alone in 2008. The point is that in the right environment, bonds can be extremely risky.
So what is an investor to do? First, be sure to look at all types of risk, not just beta. Second, act on this knowledge by including stocks in your long-term portfolio to increase returns and protect against the ravaging effects of inflation.
Related: Bonds vs. CDs