Riskier Business: Bonds or Stocks?

In the April issue of Kiplinger’s Personal Finance Magazine, there’s an article, Why stokcs are a Bargain, by James K. Glassman and a section of the paper is devoted to the discussion of which is riskier, bonds or stocks. The article uses the following examples to show what investors can expect by investing in various securities:

• Treasury inflation-protected securities (TIPS): Vanguard Inflation-Protected Securities fund (VIPSX)
• Long term Treasury bonds: Dreyfus U.S. Treasury Long-Term (DRGBX)
• Stock index: Vanguard S&P 500 Index fund (VFINX)
• US stocks: Fidelity Contrafund (FCNTX)

According to Morningstar data, for a 3-year period, the risk (defined as standard deviation, till February 28, 2007) and reward (annualized return, till March 15, 2007) of the above securities are given as follows:

Symbol	Standard deviation	3-yr return (%)
VIPSX	5.02	2.98
DRGBX	7.04	4.06
VFINX	7.08	9.98
FCNTX	9.05	13.83

The relationship between risk and reward can be better illustrated by this plot:

While we always consider Treasury bills/bonds as save heaven since they are backed by the full faith of the US government, the stability of Treasury securities is only a relative term. Investors are guaranteed a fixed return when they buy Treasury securities and hold them to maturity, but inflation will take a big bite of that return. Currently, 10-year Treasury bond has a yield of 4.54%, while the inflation rate of February 2007 is at 2.42% and the average inflation rate of the past three years is 3.10%. If we factor in the inflation, the real returns from bonds/bills are far less than the face numbers. And if we plot the data as risk against reward, it will look more interesting:

Contrary to what we usually believe that investing in Treasury bills/bonds involves less risk, the relationship between bonds and stocks says investing in stocks is far more rewarding than investing in bonds, even for a period of three years. Though the fact that we are in a bull market since 2003 may tilt the balance toward stocks for the above examples, the Kiplinger’s article uses historical data to argue that over long-term, stocks produced far more returns than bonds did. That being said, does it mean that we should ignore bonds and bills and put all of our money in stocks? A simple example will answer this question. In 2001 and 2002, VIPSX’s total returns are 7.6% and 16.6%, respectively. During the same time period, VFINX returned -12.0% and -22.2% annually, respectively. Eventually, it all comes down to a sound asset allocation plan that fits an investor’s investment objectives.

The following risk-reward chart based on the Efficient Frontier thory should give us some ideas on the optimum relationship between risk and rewards.

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