While we often find increasing holdings in bonds and cash to be a smart and strategic decision, clinging to both can in fact increase risks, especially if done for long periods of time.
Contrary to conventional wisdom, bonds are not always more conservative than stocks. They are more conservative—at a price. Therefore, bonds are more risky than stocks at a price. This means, at some price, having bonds—especially in large amounts—could actually raise risks.
Take the current environment. Interest rates across maturities and credit quality have fallen to historic lows. Starved for yield in today’s low-interest-rate environment, investors have bought longer-term and lesser-quality income securities. High-yield bonds are now a misnomer; they just offer yield.
Lower yields mean investors have been paying higher prices. The question is, do these securities today compensate investors for the risks assumed? Inflation risk, interest rate risk, credit risk and sometimes liquidity risk face any investor. Today the market assumes these risks to be low, so low that many cash savings vehicles and bonds mean a high likelihood that real wealth will be eroded over time.
In other words, higher prices paid for perceived income and safety may mean a lower margin of safety for investors. To shield themselves from the short-term vicissitudes of the economy and market, many investors are assuming other risks that grow over time such as the likelihood of inflation or credit risk.
We think for most investors today, a modest allocation in stocks—particularly those of quality and growth—can actually improve the risk/return of a portfolio, especially over time.
Let us show you how to rethink “conservative.”