For some investors, stocks may actually be less risky than bonds and other assets
The conventional investing wisdom says that stocks are riskier than bonds. After all, stocks can tumble 40% over the course of a few months while a rough patch for bonds is a 5% slide.
But is it necessarily true for all investors? Might there be cases when stocks are actually less risky?
Even if you can't stand the stock market's dips and dives, some recent studies suggest it may make sense to own more stocks — up to 80% of your portfolio — if you don't need the money for 20 years or more.
Are Stocks Riskier than Bonds for All Investors?
The longer the time until you need your money, the less risky stocks become. Sure, stocks may still rise and fall in any given year but they are more likely to rebound and blast higher over longer periods.
In fact, the longest time it’s taken for the S&P 500 to retake old highs was 81 months after the August 2000 high of the tech bubble. It took 66 months to break the previous record set before the 2008 financial crisis.
That means, if you’ve got more than a decade of investing left, your risk in stocks drops to much less than you might think.
Stocks aren't particularly risky if held for a long time compared to other assets like bonds
says Michael Finke, a professor of personal financial planning at Texas Tech University in Lubbock.
Finke recently co-authored a paper, Optimal Portfolios for the Long Run, to answer a classic question: What's the best mix of stocks, bonds and cash for investors with at least 20-year time horizons?
To find out, the researchers crunched 113 years of data on stock returns from 20 industrialized countries. They analyzed the returns across overlapping 20-year periods and plugged in formulas to see what the returns would look like for investors with various appetites for risk.
The bottom line, stocks are not as risky as most people think. The study found that, to get the best returns, even the most risk-averse investors should hold 60% to 70% in stocks if they have more than a few decades to invest. Investors that can tolerate a little more risk may want to invest even more in stocks.
If Stocks are Less Risky, Should You Buy More?
Finke acknowledges that the study's conclusions may sound “crazy,” and shouldn't be taken as advice to dump your bonds and buy more stocks.
Indeed, while academic research may support loading up on stocks, investors need to consider personal factors.
For example, most advisers suggest trimming stock exposure as investors near retirement age and want more stable returns. If you need regular income, an optimal portfolio may include more bonds or other income-producing investments. If your holding period is less than 10 years, some advisers suggest owning just 30% in stocks.
It's also crucial to know how you'd react if the market tumbled 30% in a short time — say six months. For many people, an “optimal” portfolio isn't one with the highest value after 20 or 30 years — it's one that lets them sleep at night.
“People care about short-term volatility,” says Finke. “It makes them unhappy even if they're not spending the money.” For these investors, it may make sense to hold less stocks since that may make them less likely to sell when the market is falling.
It sets us up for one of the most important ideas in investing, asset allocation and a key reason I don't worry about a stock market crash. That’s how much of your total investments you should have in different assets; i.e. stocks, bonds, real estate and alternatives depending on how much time you have left before retirement.
The graphic below suggests the percentage of your portfolio to invest in each asset class depending on how many years you have before needing to withdraw the money.
A few important points about the graphic and how you can use it to plan your investment strategy:
- Notice that the amount in stocks is never 100% or zero. You should always hold some other assets to diversify and to take advantage of stock market corrections. You should also hold some stocks even in retirement to protect against inflation.
- You don’t need to change your investments each year to meet new asset allocation targets. Rebalance every five or ten years to cut down on commissions.
- Alternative investments include private equity and hedge funds which may not be necessary or suitable for some investors. Most investors would be fine adding this portion to stocks instead.
- These percentages are only guidance based on risk in each asset class and average investor risk tolerance/return needs by age. Your own needs may differ.
Check out this series on investing by age and how to change your investments as you get older.
Time is on your side in Stocks versus Bonds
If you can handle the bumps, studies do suggest that the risks of owning stocks drop over time.
Statistically, the market's average return typically bounces around by about 20% over any 12-month period, according to research from Fidelity Investments. But that measure of volatility, called standard deviation, declines to 12% after three years. It drops to 9% after five years and dwindles to less than 2% over 30-year period.
Essentially, that makes stock returns more stable than intermediate-term government bonds, which have a 2.5% standard deviation after 30 years.
Why are stock returns so volatile near-term and stable long-term? Investor behavior, for one thing. Despite lots of evidence that stocks are riskier in the near term, the average holding period for U.S. stocks is just one year.
Further, markets are driven by short-term factors like changes in corporate profits and the outlook for the economy. These things bounce around quite a bit quarter-to-quarter, jostling the market. Eventually, though, economic factors revert to long-term averages and stock returns follow a similar pattern.
A Balanced Approach to Risk in Stocks
Even if you're not comfortable holding more stocks there are ways to potentially enhance your returns.
Rebalancing, for example, can boost your long-term results. People have a tendency to become risk-tolerant during bull markets — buying stocks when prices are high. And they grow fearful in bear markets, selling when prices are low. To avoid that mistake, you should set a long-term target mix for your investments and rebalance your portfolio every year or every few years.
This means setting a reminder every few years to take a look at the amount of money you have invested in the different asset classes. If stocks have zoomed higher, you likely have a much higher percentage invested relative to other assets.
You rebalance by selling some of the assets that have grown beyond your portfolio target and buying those that have lagged. It’s a great way to buy-low and sell-high without having to time the stock market.
Stocks can be less risky compared to bonds and other assets depending on your personal factors. Don’t blindly follow investing rules but use your investor plan to guide your investments to better reach your financial goals.