Bonds VS Stocks – Stocks Can Be Less Risky Than Bonds

Investors are often told by the financial media and experts that stocks are riskier investments than bonds. So much so that it has become almost conventional wisdom, and to state otherwise risks making one look rather foolish. However, in his most recent letter to Berkshire Hathaway shareholders, this is precisely what a certain Warren Buffett did.

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“It is a terrible mistake for investors with long-term horizons – among them, pension funds, college endowments and savings-minded individuals – to measure their investment ‘risk’ by their portfolio’s ratio of bonds to stocks. Often, high-grade bonds in an investment portfolio increase its risk,” Buffett wrote.

Why would high-grade bonds increase a portfolio’s risk? Aren’t high-grade bonds supposed to be safe? “Investing is an activity in which consumption today is foregone in an attempt to allow greater consumption at a later date,” Buffett stated. “‘Risk is the possibility that this objective won’t be attained.” In other words, Buffett defined risk as the likelihood of loss of purchasing power, which is effectively what money really is (anyone who doubts this should try paying for his neighbourhood coffee shop’s chicken rice with 1965 prices).

US Treasury Bonds – Not so risk-free

He noted that back in 2012, a five-year U.S. Treasury bond had a yield to maturity of 0.88% per annum and that U.S. Treasury bonds were generally considered to be “risk-free” investments. But there was one problem – the investor who bought the bond was in fact taking a relatively high risk because if annual inflation was anything higher than 0.88% in the following five years, he would have lost purchasing power. So taking inflation into account, high-grade bonds could actually increase a portfolio’s risk. In contrast, U.S. stocks had earned more than 10% annually on shareholders’ equity over time, so for stocks to beat 0.88% annually was “hardly a Herculean achievement”, as Buffett put it. And the results proved to be the case, with U.S. stocks rising by 15.79% per annum from end 2012 till end 2017.

The inflation rate in the U.S. and Singapore has been low for a number of years now, so it probably hasn’t factored in most people’s thinking. However it is worth noting that inflation in the U.S. averaged 2.5% per annum for 25 years (1949 – 1973) before averaging 8.45% per annum in the next 10 years (1974 – 1983). If you were an investor at the start of 1974 thinking that buying a ten-year U.S. Treasury bond would protect the value of your money, you would have been disappointed despite earning 6.99% per annum. A very decent return by any means, but it still lost out to inflation. U.S. equities, on the other hand, delivered 10.66% per annum over the same period.

Bond investing basics – Some Caveats to note

There are several important caveats to take note of. The first one, as Buffett mentioned, is the investor’s time horizon. In the short term – which I would suggest is anything within a five year period – stocks could very well be riskier than bonds. However, the longer one’s investment time horizon, the less risky investing in stocks actually becomes, and the greater the likelihood that stocks will outperform bonds. Hence it makes sense for investors with multi-decade time horizons to invest into stocks rather than bonds.

The second caveat is that it depends on the investor’s individual need, ability, and willingness to tolerate fluctuations in the value of his portfolio. Stock prices are undoubtedly more volatile than that of bonds, and if the investor is unable to withstand the financial or emotional pressures to pull their investments out of the stock market when markets are down, he can certainly lose money. Thus stocks may not be suitable for everyone – even if one has a long investment time horizon.

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As an aside, many in the financial industry tend to equate volatility with risk, which is used to justify saying that stocks are in fact riskier than stocks. Buffett has posited that that they are not the same thing. “Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray,” Buffett wrote in his 2014 shareholder letter. Francois Rochon of Giverny Capital said, “Volatility is not synonymous of risk, but – for those who truly understand it – of wealth.” Indeed, investors with a long time horizon who recognize that volatility can present opportunity can benefit from market volatility. One simple way to do so would be to follow the legendary mutual fund manager Peter Lynch’s advice to just buy more stocks whenever the stock market falls by 10%, which should help you to achieve better than average returns over the long run.

The third caveat is that the probability of stocks being less risky than bonds naturally depends on what bond yields are like at the time one is investing. As mentioned earlier, the U.S. five-year Treasury bond yield back in 2012 was about 0.88% per annum, and the ten-year bond yield was about 2% per annum, so they were yielding below the U.S. long term average inflation rate of 3.27% per annum.[1] As of May 2018, the ten-year U.S. Treasury bond yield (and even the thirty-year bond yield) is now roughly 3% per annum. Our own ten-year Singapore Government bond is now about 2.5% per annum, which is slightly below Singapore’s long term average inflation rate of 2.6%.[2]

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So if you are investing for the long term (such as for a retirement portfolio, for your children’s inheritance, or even for a charitable cause) and you are willing and able to tolerate volatility, then considering how low-yielding bonds are now, it makes a lot more sense to be investing into stocks rather than bonds. Not only would the returns be better, but as Buffett put it – they would be less risky too.

This is an original article written by Sean Cheng, Portfolio Manager at Providend, Singapore’s Fee-only Retirement Financial Adviser.

[1] Trading Economics. “Singapore Inflation Rate.” https://tradingeconomics.com/united-states/inflation-cpi (accessed June 4, 2018).
[2] Trading Economics. “United States Inflation Rate.” https://tradingeconomics.com/singapore/inflation-cpi (accessed June 4, 2018).

(By Sean Cheng, Portfolio Manager of Providend Ltd)

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