Many investors believe that in times like these it’s important to seek safety above everything else. That’s only natural during periods of economic upheaval, but you should understand that seeking safety can be risky.
Over the long-term, investment returns are related to risk. That is, if you accept more risk, you usually receive better returns. Conversely, lower risk investments typically don’t perform as well. You are giving up some upside potential in return for more stability on the downside.
Over the past year or so, however, lower risk investments like bonds have declined in value alongside “riskier” stocks. Trying to avoid risk has actually proven to be risky.
By some measures, the volatility of bonds has equaled or exceeded the volatility of stocks over the past few months. You’re not alone if you find this bewildering.
HOW RISK AND RETURN CAN DECOUPLE
Part of the confusion can be traced to the relatively good performance of balanced portfolios over the past couple of decades. During some recent time periods, a balanced 60/40 portfolio,(60% stocks/40%bonds), actually outperformed the S&P 500 (100% stocks). That is, you received more return with less risk. One example of this is 2000-2021: The S&P 500 produced a 5.1% annual return for this period of time; the 60/40 portfolio posted a 7.9% annual return. Much of this difference is attributable to the 2007-08 timeframe when stocks cratered while bonds increased in value.
Of course, you probably don’t need an investment portfolio composed solely of stocks. Bonds usually help smooth out volatility and this allows you to withstand the sometimes, wild ride inherent in owning stocks. But, bonds typically aren’t a good hedge against inflation and we are clearly experiencing high rates of inflation at present.
The target allocation of your investment portfolio should ultimately be governed by only two things: your particular financial planning goals; and your ability to accept volatility within your portfolio.
It’s also important to remember that the largest contributor to good long-term investment outcomes is your own behavior. How you react to short-term market noise and volatility trumps everything else.
WHY SEEKING SAFETY CAN BE A MISTAKE
With all the financial market turbulence, some investors are tempted to seek certainty by purchasing an annuity. To borrow the words of Nancy Reagan, “Just say no.” The returns from single premium annuities include the return of your own money, not just earnings on your money. High costs, limited flexibility, and a purposely complicated structure combine to create a very poor investment.
Rising interest rates combined with the most significant inflation in three decades have created a tough time for bonds. Eventually, the financial dials will be recalibrated back to their normal settings, but for now, bonds carry more risk than you might like.
Depending on your age and stage of life, a “conservative” portfolio composed mostly of bonds may actually turn out to be very risky. Stocks are the most reliable inflation hedge in the investment arsenal. Don’t let your fear of short-term volatility ruin your financial future. Start there.
Related: How to Choose a Financial Planner