Some of those who argue for including bonds in a diversified portfolio (we might say “di-worse-ified”) would say that bonds reduce risk by reducing volatility. However, we think there’s a big flaw in this reasoning: Simply put, volatility is not risk. Risk is the chance of losing your purchasing power or, more broadly, failing to achieve your investment objectives. If you invest in bonds in order to try to produce after-tax, after-inflation purchasing power over a typical retirement time horizon, it’s going to be very cold comfort knowing that your portfolio was less volatile if it fails to support you in your later retirement years. Similarly, will a stock portfolio necessarily reduce you to a quivering mass of fear if it temporarily declines in value from time to time en route to increasing your purchasing power through long-term, stock-like returns? So we repeat: Volatility is simply not the same as risk. The sooner investors accept this piece of common sense, the sooner they can start to think about realistic investment choices. Stocks are appropriate for investors with a long-term time horizon (which may include investing for one’s heirs) and with investment objectives of growth and income. Shorter-term, high-quality bonds are appropriate for investors who are willing to sacrifice significant returns in order to achieve less short-term volatility. Long-term and “high-yield” (think Greek, Russian and other junk-quality) bonds are appropriate for speculation.
Feb 2015