Stocks deliver some of the highest returns of all investments but also come with a lot of risk. That makes stocks an excellent choice for your long-term needs. What if you have a short time horizon or are intimidated by risky investments? You might be searching for a safe investment. Does such a thing exist?
Bonds: Less risky, but not safe.
As a bondholder, you play the role of a lender to governments and corporations. You receive a stream of interest payments for each bond you buy until you get paid back in full.
Because bonds earn fixed income, their prices tend to change less than stocks. It doesn't matter if companies do well or poorly, they just need to pay their bills on time.
Just because bond prices are more stable than stocks, doesn't mean that bonds are safe investments. Credit risk, prepayment risk, and interest rate risk are some of the most notable risks of bonds.
Credit Risk: Like any lender, you're taking a risk that the borrower doesn't pay you on time, in full, or at all. Just as with personal loans, borrowers with more credit risk pay higher interest rates. You don't need a default on the loan to make a bond investment turn sour. It only takes a decline in a borrower's perceived credit worthiness to send bond prices into a tailspin.
Prepayment risk: Consider a bank that issues 30-year fixed-rate mortgages to homebuyers. If interest rates drop too much, homeowners might refinance to a lower rate by paying off the higher rate mortgage with a lower rate one. Lenders can't count on high interest payments for the entire loan term.
Interest Rate Risk: Rising rates can be disastrous for lenders, especially those holding long-term loans. Imagine if yesterday you loaned money to someone on a fixed 30-year loan only to find that interest rates had doubled overnight. Suddenly, you earn only half as much as others who lend the same amount of money to new borrowers today. You'd be left holding the bag with nobody to buy that loan off of you except for at a steep discount. Holding the bond until maturity is equally bad as you'll miss out on the extra income, locking in the same loss as an opportunity cost.
Example: Silicon Valley, Signature, and First Western banks all loaded up on long-term, "low-risk" government bonds in 2021 at rock bottom rates. Investing in stocks was out of the question due to their high risk, but US Government bonds appeared to be a safe haven. These banks forgot that long-term bonds have the highest interest rate risk. Ultimately, these banks failed because the value of their supposedly safe bond portfolio dropped due to a year of rising interest rates.
Cash and Treasury Bills: Still not entirely safe.
What if you were able to minimize credit risk, prepayment risk, and interest rate risk? You'll end up investing in cash and equivalents like CDs, money market funds, and Treasury bills.
Even cash has residual credit risk. The US Government could finally fumble on the debt ceiling, banks can fail, cash under the mattress can burn up in a fire or be stolen.
Furthermore, cash loses value thanks to inflation. You won't see your bank account value go down, but you'll find that the dollar doesn't go as far as it used to when paying for things.
Ultimately, the biggest risk of keeping your savings in cash is that you might not have enough saved to pay for your future goals after inflation.
Embrace some forms of risk to avoid others
Over the long term, stocks are expected to return more than bonds, which return more than cash in exchange for greater uncertainty.
Below is a chart that shows the historical drawdowns of US Stocks, US Bonds, and Cash from 1987 - 2023. As expected, stocks are risky in the conventional sense. They can lose lots of value before recovering years later. Bonds often maintain their value, but not always. They had a terrible year in 2022, almost as bad as stocks. Anyone who heavily relied on bonds for stability would have been in trouble.
Below you'll see how markets reward investors for taking on increasing amounts of risk and how even cash (invested in safe, short-term investments) can lose value to inflation.
Risk is unavoidable. Would you rather risk losing money on stocks and bonds in hopes of living a better life? Or would you rather maintain account stability, but lose purchasing power to inflation and risk not having enough to cover your needs?
The answer depends on your personality, your goals, and the details of your finances. At Left Coast, we get to know our clients so we can help them navigate the many risks they face. We build models that project your income, expenses, and goals. We simulate thousands of possibilities and perform a sensitivity analysis to determine which risks pose threats.
Below is an example of a client who is at higher risk of running out of money in retirement if they keep their savings entirely in cash than if they went all-in on stocks despite their volatility. Our stress testing shows that this client can have a better outcome by going all-in on stocks even if they immediately drop by 20%.
As a counterexample, here is another client who is better served by dialing back their stock portfolio to something more conservative if they cannot adapt their spending to market changes.
Which is better for you? We won't know until we run the numbers and learn your attitude toward risk.
Comentários