Think an All-Bonds Portfolio is Safest? Think Again
The idea that stocks are riskier than bonds is widely accepted at face value in finance and investing. Stock prices tend to swing both higher and lower, and more frequently, than bond prices, and unlike with a bond, owning shares in a company doesn’t come with a commitment that your investment principal will be paid back at a future date.
As Modern Portfolio Theory holds, to compensate for this higher risk, an investor in equities should expect to earn a higher rate of return over time than an investor in fixed income. This concept is generally called the “equity risk premium” and historically, broad indices of stocks have outperformed their fixed income counterparts, while experiencing much higher volatility in returns, also known as standard deviation.
However, a popular misconception among many investors is that a portfolio invested only in fixed income is the “least risky” possible portfolio. This view ignores two key issues. First, not all bonds are created equal in terms of minimizing volatility and risk – a long-duration bond with poor credit quality typically has substantially higher volatility than a short-duration treasury. Second, by virtue of being assets that do not move in tandem (and may even move inversely), a mix of stocks and bonds can actually result in an overall portfolio with lower volatility than bonds alone.