Stocks are risky and bonds are safe, right? This is the conventional wisdom we’ve all heard time and time again. But history shows that a lot depends on your investment horizon.
When academics, journalists and market commentators refer to risk, they're often talking about how much the value of an investment fluctuates. But for most of us, our primary financial risk is not having enough money to achieve our goals in the long-term. And with that understanding of risk in mind, the so-called “risky” assets may actually be less risky over the long-term.
This chart shows how often someone invested in the U.S. stock market and in U.S. 10-year government bonds would have lost money over various holding periods during the past 145 years. The chart shows the probability of loss before and after inflation (i.e. in nominal and real terms). An investment bought for $10 and sold for $10 several years later has broken even in nominal terms, but it's lost money in real terms - because of inflation, that $10 buys less at the end of the period than it did at the start.
The data show that if you need your money within a year or two, the stock market is indeed a risky place to invest it. Stocks have delivered losses in about a third of all one-year periods. Sometimes the magnitude of those losses can be substantial - for example, 2008 saw a dramatic drop. Bonds, on the other hand, have only lost money in approximately 10% of one-year periods and the severity of those losses is typically mild.
If you're investing for longer-term goals, however, you might view the risks differently. The stock market has only lost money in 3% of all 10-year periods and has only failed to keep pace with inflation 12% of the time. Over 20-year holding periods, stocks have never returned less than inflation. And usually they deliver much more: the average inflation-adjusted return from stocks has been north of 6% per year.
And what about bonds? While they have never lost money over a 10-year period in nominal terms, they have failed to keep pace with inflation 28% of the time. In other words, in more than one-quarter of all historical 10-year periods, bonds would have left you with less purchasing power at the end of the period than you had at the beginning. Even over 20-year periods, bonds have delivered a loss after inflation about a quarter of the time.
With yields on 10-year government bonds in UK, Canada and the U.S. currently lower than the prevailing rate of inflation, there is a non-trivial chance that bonds will deliver a loss after inflation during the next 10 years.
Why This Matters
Lots of people are afraid to invest in stocks because they think they're too risky. So instead they invest for long-term goals in bank accounts, Cash ISA's, and government bonds. But as we've seen, the data show that over long periods of time the risk of investing in stocks is much less than people think, and may even be less than the risk of bonds, once you factor in inflation. So investors who shun stocks to avoid volatility pay a steep price in the long-run.
Of course, this only holds true for a broadly diversified basket of stocks. An under-diversified portfolio of stocks would deliver losses more frequently - even over long time horizons. This is one reason why Wealthsimple invests in passive mutual funds, because it gives clients exposure to thousands of stocks from around the world.
None of this means that there is no place for bonds in your portfolio either. Their important role is to reduce volatility. If you are in or approaching retirement this is crucial. But even if you're not in that phase of life, you might find the that the ups and downs associated with an all stock portfolio are difficult to stomach. Holding bonds may cost you some return over time, but if it helps you stick to your plan, it’s well worth it.