For investors, volatility can be scary. And stocks are always going to be much more volatile than more conservative investments like bonds. But when deciding whether a portfolio with only a small allocation to stocks or none at all is right for you, it's important to examine other risks that may not be as obvious.
The No. 1 reason many investors may choose to avoid stocks is because they get emotional about their investments, says John Thompson, vice president at asset allocation specialist Ibbotson Associates in Chicago. It can be tough to watch your portfolio rise and fall each day based on stock market movements. If you avoid stocks altogether, you don't have to worry about day-to-day gyrations in the stock market. "Obviously, [investors] still have to worry about bond markets going up and down," Thompson says. "But they don't have to worry about the big swings."
On the other hand, the reasoning for allocating a small portion of your portfolio to stocks is two-fold. Historically, stocks have outperformed bonds, and research shows that diversification lowers risk. The latter may not sound intuitive, but over time, investing in a combination of stocks and bonds actually reduces the overall risk of your portfolio. "We would never propose a portfolio for any investor, no matter how conservative they are, that is completely devoid of stocks," says Nathan Rowader, director of investments for Forward Management in San Francisco. "Stocks are an important source of growth."
From the beginning of 1976 through the end of June, an all-bond portfolio invested entirely in the Barclays Capital U.S. Aggregate Bond Index—the most commonly-cited investment-grade bond index—would have returned less and exhibited more risk (as measured by its standard deviation) than a portfolio with a 5 percent allocation to the S&P 500 stock index, according to Ibbotson Associates. If you raised your stock allocation to 20 percent, each year your portfolio would have returned almost an additional percentage point, on average, over the same time period, with only a slightly higher standard deviation. "The risk differences are not that great, but the return is," Thompson says.
Put another way, if you had invested $10,000 in the Barclays Capital U.S. Aggregate Bond Index at the beginning of 1976, it would have been worth almost $169,000 at the end of June. Over the same time period, a portfolio with a 20 percent allocation to stocks would have netted you close to $217,000. That's why, even for conservative investors who are in or nearing retirement, Thompson says he would advise allocating at least a small portion of their portfolio to stocks. "We would still suggest up to 20 percent [in stocks] because even in retirement, you have to think about longevity risk," he says, referring to the risk of outliving your savings.
[Graph: See $10,000 Grow Over Time.]
Over time, a stockless portfolio would struggle to outpace the rate of inflation—the rise in the price of goods and services over time. For ultra-conservative, fixed-income investors, Paul Dietrich, CEO of Orange, Conn.-based Foxhall Capital Management, says: "I just fear that they're losing far more in purchasing power of their dollar than they would be accepting slightly more risk in the stock market." Interest rates have been set at virtually zero for almost three years now, and the Federal Reserve has initiated two separate phases of quantitative easing, in which it bought a combination of mortgage-backed securities and treasury bonds in hopes of pushing interest rates even lower to help spur a recovery. Today, the yield on the 10-year treasury bond, which is known as one of the benchmark rates in the bond market, is trading near 3 percent, which is quite low by historical standards.
To compete with inflation over time, investors have several options. But these alternatives each have their own fair share of risks:
High-yield bonds. These bonds come with higher payouts, but also higher risks. High-yield bonds are more likely to default than investment-grade IOUs. Investors must also be prepared for a wild ride. In 2008, the average high-yield fund lost about 26 percent, but rocketed back about 47 percent in 2009, according to fund tracker Morningstar. "High-yield bonds can be quite volatile ... and they can sometimes mimic the stock market during crises," Thompson says.
Emerging markets bonds. Investors could look abroad to higher growth environments like the emerging markets, where many central banks have recently raised interest rates. While emerging markets may offer higher yields, they are also much less transparent. "You have to be aware of the risks of going into those markets, but you have to take on a little bit of that risk to diversify your treasury portfolio to make sure you aren't concentrating your risk in one asset class," Thompson says.
Commodities. Rowader says commodities make up an important part of a long-term diversified portfolio. The problem is that there is plenty of volatility in the commodities market as well. "Investors are afraid of stocks, but they do need to consider ways that they can add growth to their portfolio, and commodities is a way to do that," Rowader says. "But I think a lot of people are just as nervous about commodities as they are about stocks."
The bottom line: Regardless of how you decide to invest, you'll have to take on risk in some form.