Stocks or bonds: Which are riskier? It depends how you measure risk, by volatility, price fluctuations, or terminal wealth.
Conventional wisdom says stocks are a riskier investment than bonds. But IESE's Javier Estrada says it depends how you define risk.
Sure, stocks tend to be more volatile than bonds. But, to paraphrase Warren Buffet's investment partner Charlie Munger, what difference does extra volatility make so long as it all works out in the end?
Working out in the end is the focus of Estrada's empirical study spanning 19 countries over 110 years. The professor of finance analyzes the terminal wealth resulting from an initial $100 investment in either stocks or bonds held for 10, 20 and 30 years (measuring all possible overlapping holding periods between 1900 and 2009).
The results: Stocks win. For long-term investors, stocks offer more upside potential and more downside protection than bonds, even when "tail risks" strike.
What tail risk?
Tail risks are extreme events that have a large impact on a portfolio but a very low probability of occurring. (As the standard distribution of returns follows a "bell curve," both the upper and the lower extremes or edges of the bell are described as the tails.)
So, why focus on tail risks? Estrada explains: "Most investors tolerate moderate levels of volatility and losses, which are typically seen as inherent to investing. What investors fear the most, and what has a big influence on their investment decisions, are extreme events, often called outliers or black swans. Hence the approach discussed here that emphasizes tail risks."
Eyes on the prize: terminal wealth
Specifically, Estrada looks to the bottom 10, 5 and 1 percent of investment results for both stocks and bonds and finds that even in these bad (to worst) case scenarios, stocks offered more investment protection than bonds in the 10-, 20- and 30-year holding periods for the countries studied (with a few exceptions). For long term investors, stocks have been less "risky" than bonds if risk is measured with terminal wealth in mind.
For example, look at a $100 investment in stocks vs. a $100 investment in bonds held over 30 years in two global portfolios (of the 19 countries in the study) — one of stocks and the other of bonds. If you were unlucky enough to land in the bottom 5 percent of results for a 30-year stretch, you saw your investment in bonds fall considerably (to $58 adjusted for inflation), with terminal wealth more than 40 percent below the initial investment. But if you were in the bottom 5 percent of returns for stocks, you saw your initial investment merely double (to $216, adjusted for inflation) over 30 years. Put another way, if the 5-percent "lower tail risk" struck your pension fund, you tended to be much better (272 percent better) off in stocks.
And what about the upside potential? For the average returns over 30 years, $100 in stocks yielded $622, on average, while $100 in bonds yielded $188, on average. For perspective, Estrada also looks at the "upper tail" terminal wealth and finds $100 in stocks yielding $1,281 in the upper 5 percent of returns and bonds yielding $568.
Risk: bumpy ride or final tally?
Estrada sums up: "Investors who focus on uncertainty are likely to view stocks as riskier than bonds, and those who focus on long-term terminal wealth are likely to view stocks as less risky than bonds even if they are concerned with tail risks." These are the conclusions reached by his study because even when investors were unlucky enough to land in the bottom 10, 5 or 1 percent of the distribution curve, they were better off in stocks than bonds — with very few exceptions.
In his article for the Journal of Asset Management on the study, Estrada notes that his "rethink" of risk is especially relevant to younger investors saving for retirement. "For this type of investor, how relevant are the short-term fluctuations in the value of his portfolio that will inevitably occur along the way?" If that profile of investor can hold on for the duration, the bumpier road might work out best in the end.
See also "Retire at Your Own Risk" and "A Comforting Read in Times of Stock Market Volatility"
FAQs
Given the numerous reasons a company's business can decline, stocks are typically riskier than bonds. However, with that higher risk can come higher returns. The market's average annual return is about 10%, not accounting for inflation.
Is stock a riskier investment than bonds Why or why not? ›
When it comes to risk, there's a general rule of thumb in investing. The riskier an investment is, the higher the potential to make a gain… but the chance of a loss is also higher. Shares are generally deemed riskier than bonds because swings in price are more severe.
Are stocks considered a less risky investment than bonds True False? ›
Stocks are generally considered riskier than bonds. Even though they have the potential for higher returns than bonds, they also have the potential for lower returns.
Is a bond typically considered to be safer than a stock but it still has risks? ›
Bonds typically have less downside than stocks, but it is still possible for bonds to lose considerable value, especially with rising interest rates. Interest rate hikes make existing bonds less valuable because investors can get higher yields with newly released bonds.
Why do stocks do better than bonds? ›
Stocks provide greater return potential than bonds, but with greater volatility along the way. Bonds are issued and sold as a "safe" alternative to the generally bumpy ride of the stock market. Stocks involve greater risk, but with the opportunity of greater return.
Do stocks have the highest risk? ›
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But there are no guarantees of profits when you buy stock, which makes stock one of the most risky investments. If a company doesn't do well or falls out of favor with investors, its stock can fall in price, and investors could lose money.
Do stocks always outperform bonds? ›
Even over the longest investment horizons, there is a significant likelihood that bonds will outperform stocks. One of the most common charts in all of finance is the relative performance of stocks vs. bonds in the US in the long run. But as with all long-term historical data, there is a huge risk of survivorship bias.
What is the average return on bonds? ›
The bond market is a wide field, with many different categories of assets. In general, you can expect a return of between 4% and 5% if you invest in this market, but it will range based on what you purchase and how long you hold those assets.
Should you buy bonds when interest rates are high? ›
Should I only buy bonds when interest rates are high? There are advantages to purchasing bonds after interest rates have risen. Along with generating a larger income stream, such bonds may be subject to less interest rate risk, as there may be a reduced chance of rates moving significantly higher from current levels.
Why are bonds less risky than stocks quizlet? ›
Generally, bonds are considered less risky than stocks because bondholders are paid before stockholders.
Cash is the most liquid asset possible as it is already in the form of money. This includes physical cash, savings account balances, and checking account balances.
What is one disadvantage of buying stocks? ›
Disadvantages of investing in stocks Stocks have some distinct disadvantages of which individual investors should be aware: Stock prices are risky and volatile. Prices can be erratic, rising and declining quickly, often in relation to companies' policies, which individual investors do not influence.
How much would I need to save monthly to have $1 million when I retire? ›
Suppose you're starting from scratch and have no savings. You'd need to invest around $13,000 per month to save a million dollars in five years, assuming a 7% annual rate of return and 3% inflation rate. For a rate of return of 5%, you'd need to save around $14,700 per month.
Are bonds considered high risk? ›
Bonds tend to be much less volatile than stocks and move in response to a number of factors such as interest rates (more below). Less risky than stocks. Bonds are less risky than stocks, and are among the best low-risk investments.
Why are bonds bad? ›
All bonds carry some degree of "credit risk," or the risk that the bond issuer may default on one or more payments before the bond reaches maturity. In the event of a default, you may lose some or all of the income you were entitled to, and even some or all of principal amount invested.
Does bonds have a high risk? ›
Bonds tend to be much less volatile than stocks and move in response to a number of factors such as interest rates (more below). Less risky than stocks. Bonds are less risky than stocks, and are among the best low-risk investments.
Which investment choice carries the greatest price risk? ›
Answer and Explanation:
Explanation: Investment in stocks is riskier compared to investment in other forms like government bonds, which are usually risk-free securities, certificates of deposit, cash, and equivalents.
What is safer than stocks? ›
Safe assets are those that allow investors to preserve capital without a high risk of potential losses. Such assets include Treasurys, CDs, money market funds, and annuities.
