Bonds and Risk Management

FINANCIAL TOOL

Bonds and Risk Management

Bonds are often touted as lower risk than stocks.

When markets get a bit choppy, bonds often outperform stocks during these shorter periods of time. Not always, but in most circumstances.

But what isn’t often discussed are the types of risks that are inherent in bonds as compared with stocks.

Bond exposure as part of a total portfolio is meant as a way of achieving slightly better returns than cash while reducing the magnitude of downward (and upward) swings in the portfolio’s value.

Bonds are not meant as a way to achieve meaningful long-term returns. Historically, they have surpassed the rate of inflation on average by only about 1.5%.

So the risk of these “safe havens” is this: an investor may end up with fewer assets in retirement than they need, simply because they wanted the comfort of seeing a less volatile portfolio from week to week and month to month.

The risk of not having enough, or of running a retirement account dry, is a real risk!

And unless someone is already a multimillionaire and can live off the interest alone, then they probably are going to need at least some market-like growth in order to achieve their long-term goals.

Interestingly, it doesn’t take long to see stocks start outperforming bonds on average.

Historically, stocks on average have been negative for shorter periods of time than bonds. And when returns are positive, stocks on average have dramatically outperformed bonds.

Now, bonds have their place. If someone is saving for a large purchase or otherwise near-term need, bonds are going to offer predictable returns assuming two things:

1. 1. The company or government doesn’t default, call or restructure the loan.
   2. The bond matures prior to when the investor needs the money.

And, as mentioned earlier, it can be used as part of a larger strategy that reduces average standard deviation (volatility) of a portfolio, if that portfolio requires reduced volatility due to investor preferences or needs.

In summary, bonds are more predictable than stocks in the very short-term, and over the life of the bond. But they are not “safe” in the sense that they can offer meaningful growth to someone who needs close to market-like returns over longer periods of time.

The risk of failing to achieve the needed long-term portfolio return must be balanced with the risk of downside that could happen over a 1-3 year period.