One of the most common issues that you will have to deal with when building your investment portfolio is the tradeoff of stocks vs bonds in your investment mix. The conventional wisdom regarding stocks vs bonds is that stocks are riskier than bonds. Let’s take a look at the background information that supports that conclusion, and see if it applies to your investment portfolio.

The primary advantage to bonds is that they have a fixed maturity and, ignoring the potential for the company going bankrupt, you know exactly how much money you will be getting and when. But this is only true if you hold the bonds to maturity. For a 30 year bond, that’s quite a commitment. But this is the basic assumption that is underlying the ideal that stocks are riskier than bonds.

But the average investor will invest in bonds by buying some type of bond mutual fund instead of individual bond issues. In this case the payout you will receive is NOT known ahead of time, but a bond mutual fund will vary in value just like a stock mutual fund, since there is no final bond maturity date for the mutual fund. A bond mutual funds price will vary inversely with longer term interest rates (as will a bond’s price, but the bond price is of no concern if you are holding to maturity.

So, back to our original question. Since both stocks and bond funds have a value that varies, are stocks riskier than bonds? To answer that, we have to understand what we mean by investment risk.

Traditionally market risk has been agreed to be measured by volatility. We’ve written another whole article on measuring portfolio risk, but in short it’s simply a measure of the percentage the fund price varies over time. Called the standard deviation, it also has the advantage that it weights large swings more heavily ( a 2% swing is considered to be 4 times as bad as a 1% swing).

Using the standard deviation of the annual returns as the measure of risk, measured over the bulk of the 20th century, it turns out that the standard deviation of stock returns (for large stocks) was about twice as much as the standard deviation of 20 year treasuries.

So, are stocks riskier than bonds? In a word yes. But this ignores an important consideration, which is the fact that stocks have also historically returned much more that bonds. This should be a factor in our analysis. Next we will look at one of the significant traded offs of stocks vs bonds, and come up with a suggestion of how much to invest in stocks vs bonds.