Where to take Investment Risks
Should I take risk in my stocks or bonds?
When constructing your portfolio, where do you take investment risk? Do you “gamble” in your stocks or your bonds? Wait, which one is low risk?
While risk means different things to different people, there is no reward without some risk.
So, when investing, how much risk is required for what kind of reward? Where should you take risks when investing in stocks and bonds?
Risk/Reward Trade-off of Stocks and Bonds
How risky is investing?
It depends on who you ask! Fundamentally, though, any time you have money sitting around doing nothing, the risk is 100% guaranteed that you will lose out to inflation.
So, from a certain perspective, not investing is the riskiest thing you can do with money!
Beyond that, there are always trade-offs: you can’t do two different things with the same money.
When discussing investing, we discuss the risk/return trade-off. When you take a risk like investing, you do so because you expect a reward—a monetary gain.
Now, when we are talking about risk in investing, we actually mean the probability of a loss or the probability of an asset providing less than the expected return.
This is not standard deviation—or volatility—which is often considered risk. Volatility is the short-term up and down of an asset. While short-term losses can feel horrendous and cause poor investing hygiene (such as selling low and locking in losses), the risk/return trade-off assumes you know better than to let market crashes cause you to panic sell. Market crashes are the price of admission—the reason why you make money in stocks is because you can sit on your hands and not sell when the market is tanking.
Before we consider if you should take risk in stocks or bonds (which has the best risk/reward trade-off?), let’s consider if you should take any risk at all!
Should I Avoid All Risk?
Some folks have no investment risk in their portfolio. They can’t tolerate any market risk and, thus, don’t have a portfolio! They believe that stocks and bonds are high-risk investments and avoid them altogether.
These folks usually invest in what they consider lower-risk assets. Sometimes real assets—real estate, metals, tangibles, businesses, etc.
There is nothing wrong with this approach. For them, stocks and bonds are too risky, and they usually want more control.
When the market plunges, they believe they have lost money.
Once you understand that volatility doesn’t mean risk, you are one step ahead of those who avoid “risky” stocks and bonds.
For those of us with a more favorable view of stocks and bonds, where should you take your investment risk? In stocks or bonds?
Investment Risk Location—Where to take Investment Risk
The risk/return trade-off implies that you won’t take risk unless you expect higher returns. These are the two sides to the trade-off.
Where should you go looking for risk in your portfolio such that you get an adequate return?
Do you look towards your low-risk / low-return bonds? Or your high-risk / high-return stocks? Are bonds actually low risk?
When considering Risk Location—where you take your investment risk—asset allocation and asset selection both come into play. You choose your asset allocation—the percentage of stocks vs. bonds in your portfolio—and choose which individual investments to invest in. Both address risk.
Bonds can be “risk-free” or high-risk. This spectrum is from ultra-safe short-term treasury bills all the way to junk (“High Yield”) bonds.
Bonds, by their very nature, seem low risk compared to stocks. But is that true? It depends on what you mean by risk.
When Low Risk is High Risk
Say you are invested in 100% bonds. Here, the risk may be accomplishing your investing goals! You might never have enough to retire.
The Risk/Return Trade-off implies that a 100% bond portfolio has such “low risk” that you are at high risk of failure. Future expected returns must be considered. Stocks historically have an equity risk premium—higher expected returns due to the volatility.
When High Risk is Low Risk
On the flip side, why not invest in 100% equities? If you can stomach the volatility, this is a low-risk play. Young investors have no investment risk if they don’t sell low.
For instance, young investors who dollar cost average into their retirement account have no investment risk if they don’t sell for decades.
These folks might invest in assets with the highest long-term expected returns regardless of the volatility. Again, the risk is not volatility but panicking and selling low.
The counterargument is the extreme—why stop at merely 100% stocks?
When young, why not leverage your stock investing? Invest in a 3x leveraged stock index fund??? No thanks, that’s too high risk for me. Here, volatility becomes risky because enough of a downturn—even a temporary one—can unhinge these products from their indexes.
It is, however, common to take on mortgage debt. Mortgage debt is the same as owning negative bonds. That is, by having a mortgage and choosing to invest in stocks, you are leveraging your investing and taking more risk for the potential of more return. This risk seems more appropriate as, hopefully, volatility is not correlated with your home price and human capital.
In essence, risk and reward differ when you have decades to invest. What if you don’t have decades left?
Investment Risk Location during De-Accumulation
What about someone who is in de-accumulation? One spending down a portfolio has a very different risk profile. Here, instead of volatility, Sequence of Return Risk weighs heavily.
Sequence of Returns Risk implies a prolonged series of negative market returns while you are taking withdrawals. This sequence occurs early in retirement when the portfolio is the largest, and the downturn has the largest absolute effect.
Risk allocation for those in de-accumulation includes a more conservative portfolio. This allows you to take distributions from the bond portion of your assets when stock prices fall.
Thus, those in de-accumulation can also take significant risks in the equity portion of their assets, as long as they have their overall asset allocation correct.
Are Bonds Low Risk?
Now, we can conclude that bonds are not low risk. This is not because bond funds recently took it on the nose due to rapid changes in interest rates; this is because of how and why you use bonds.
Actually, or more specifically, bonds don’t always have a good risk/reward trade-off for your investing goals.
If you are young, you might not sell for decades, and bonds may not help you reach your investing goals.
If you are not young, you might be investing in the wrong kind of bonds that are not there to perform their function during sequence of returns risk. Some bonds are highly correlated with stock returns. These high-yield (junk) bonds can be slaughtered just when you need them to cover living expenses.
So, fundamentally, here is the point: bonds are not low risk.
Don’t chase yield in bonds! This could be either by going for high-yield (junk) bonds or, sometimes, by increasing the duration.
Chasing yield means getting more money out of bonds by taking more risk. Bonds–or your “safe assets”- are not the location in your portfolio for risk.
If you need a higher return, increase your stock allocation rather than taking risk in your bonds!
Investment Risk Location and the Risk/Return Trade-off
So, the risk/return trade-off implies that risk location matters. Where to take investment risk? In the equity part of your portfolio, not in the bond part.
Remember: Investment risk is not volatility for those with an appropriate asset allocation.
Young folks have time. Older folks have safer assets (which include bonds) that buy them some time.
Where should you take the risk when considering an asset allocation of bonds and stocks?
Don’t chase yield in your bonds. Bonds are for safety and to dampen volatility. In the young, they improve investing hygiene (keep you from selling low). In those less young, they are pretty good at mitigating sequence of return risk. Bonds allow you time to take risk in stocks.
So, the surprising answer is whether stocks or bonds are riskier. The answer is yes.