Stocks vs Bonds - What's the Right Mix of Stocks and Bonds?

Every investor is face with the challenge of coming up with the right mix of assets to limit the risk in their investment portfolio to a level they are comfortable with. Of course, that level is a function of many things, including not only the temperament of the investor, but the your age, how close you are to retirement, and so forth.

Which is riskier, stocks or bonds. Let's examine each and see what you get when you buy stocks and bonds

What is a Bond? What is a Bond Fund?

A bond is really something like a load to a company. The idea is that you buy the bond at some face value (say $1000) and the company will pay interest to your for borrowing the money at the "coupon rate", or the yield of the bond, for example 5%. So each year you would receive $50 in interest for that $1000 invested. Finally, at the end of the term of the bond (often up to 30 years) you get the face value of the bond back. So after 30 years you get your money back.

That's basically what makes bonds lower risk. Ignoring for the moment the possibility that the company goes out of business, investing in a bonds gives you a very predictable cash flow, which implies a low risk.

Now the average investor does not invest in individual bonds, but may buy a bond mutual fund instead. This is a fund that will buy individual bonds from many companies or government entities, and pool them together. The disadvantage of doing this is that there is not really a term or maturity date associated with the fund, so it exposes you to more market risk as interest rates vary, but the end result is still a lower risk fund than a stock fund.

What is a Stock? Why are Stocks Riskier than Bonds?

A stock is really a small piece of ownership in a company. With it you are entitled to the dividends that the company pays, and the increase in the net worth of the company as shown in its balance sheet will eventually be reflected in the stock price. However, if business slows or some act of God puts the company out of business, or the cost of business skyrockets because of something like the price of oil, then the resulting reduction in profits will cause the market to value the company less, and the stock price goes down.

For a stock there is no real redemption point, unless the company were to be bought out by another company, or if it were to simply eventually go out of business (this actually eventually happens to most companies. Take a look at the companies that made up the Dow Jones Industrials in the first half of the 20h century, and you'll see that a surprising number of them are no longer in business>.

The flip side of that is that the company could see a ten or one hundred fold increase in business and profits, and the stock price could increase by that amount as well.

So, for those many reasons, stocks carry more risk than bonds, but investors are willing to buy them because they have more potential to increase. A bond will almost never return more than the face value as you approach its maturity, so the upside is very limited.

When we look at asset mixes, the conventional wisdom is that increasing the bond part of your portfolio will decrease the risk.

But many investors will not invest in bonds directly, but instead will be buying some type of bond mutual fund. This is different in that the payout you is NOT known ahead of time, because a bond mutual fund will fluctuate in price just as a stock fund does, since there is no final bond maturity date for most bond funds. A bond mutual funds price will vary inversely with longer term interest rates (as will a bond’s price, but the bond price is of no concern if you are holding to maturity.

What is Risk? How do I Measure It?

Most analysts agree that risk is best characterized by volatility. In summary it’s simply a way to measure how much the fund price varies day to day or month to month. It's measured using the standard deviation of the price swings and one significant characteristic is that it weights large price swings more (a price change of 2% carries 4 times the weight of a 1% swing).

Let's take a look at the longer term history of the stock market. If we measure the standard deviation of the annual returns of the market in the 20th century, the standard deviation for large cap stocks was almost 2 times the standard deviation of 20 year US treasuries bonds. That in a nutshell is why stocks are considered riskier than bonds.

But you need to note that over that same period stocks returned almost half again as much as bonds. So, if we want to maximize our returns, we can't simply hide in the safe haven of bonds.

How Much Should I Invest in Stocks vs Bonds?

The conventional rule of thumb is to allocate a percentage of your portfolio equal to 100 minus your age to equity stocks holdings, with the rest in bonds. For example, if you were sixty five years old, then you should hold 100 - 65 = 35 or thirty five percent of your investments in stocks or stock funds, and sixty five percent of your assets in bonds or bond funds.

Note however this simplified strategy assumes that you are only holding two asset classes, large cap stock funds and bond funds. It turns out that if you break your portfolio up into 5 to 10 asset classes then you can achieve a higher return while keeping the lower volatility from diversification.

There are many books written on the topic of building a diversified portfolio, on of the best is The Four Pillars of Investing, by William Bernstein. If you are up for the occasional square root, the Intelligent Asset Allocator is a great book as well.