Where to take Investment Risk: Avoid Chasing Yield
Avoid Chasing Yield! What does that even mean?
When constructing your portfolio, where do you take investment risk? Do you take Risk in your Equities or your Bonds? Are Bonds Low Risk?
Risk means different things to different people, but we all know that without some risk, there is no reward.
So, when investing, how much risk is required for what kind of reward? What is the Risk/Reward Trade-off?
Risk/Reward Trade-off and Chasing Yield
Investment Risk means different things to different people. Any time you have money sitting around, there are many different things you can do with it. Deciding to do one thing rather than another involves trade-offs: you can’t do two different things with the same money.
More specifically, when talking about investing, we are talking about the risk/return trade-off. That is, when you take a risk—like investing—you do so because you expect a reward—a monetary gain.
In investing, risk means the probability of a loss or the probability of an asset providing less than the expected return.
This is not standard deviation—or volatility—which is often considered risk. Volatility is the short term up and down of an asset. While short term losses can feel horrendous and cause poor investing hygiene (such as selling low and locking in losses), the risk/return trade-off infers more of an intermediate or longer time frame.
Where should you take investment risk in your portfolio? What has the best risk/reward trade-off? Or should I avoid risk investing?
Should I Avoid Risk Investing?
Some folks have no investment risk in their portfolio. They just can’t tolerate any market risk and thus don’t have a portfolio! They believe that stocks and bonds are high risk investments and avoid them altogether.
These folks usually invest in what they consider lower risk assets. Sometimes real assets—real estate, metals, tangibles, businesses, etc. They avoid the market and what they consider risk investing.
There is nothing wrong with this approach. For them, stocks are too risky (and bonds aren’t low risk either) and they want more control. Generally, they see volatility as risky. When the market plunges, they believe they have lost money.
We know you don’t lose money unless you sell low and lock in losses. Once you understand that volatility doesn’t mean risk, you are one step ahead of those who avoid risk investing.
For those of us with a more favorable view of stocks and bonds, where should you take your investment risk? In stocks or bonds?
Investment Risk Location—Where to take Investment Risk
The risk/return trade-off implies that you won’t take risk unless you expect higher returns. These are the two sides to the trade-off.
Where should you go looking for risk in your portfolio such that you have adequate return?
Do you look towards your low risk / low return bonds? Or, your high risk / high return stocks? Are bonds actually low risk?
When thinking about Risk Location—where you take your investment risk—asset allocation and asset selection both come into play. Not only do you choose your asset allocation—the percentage of stocks vs bonds in your portfolio—but, you also chose which individual investments to invest in. Both address risk.
Bonds can be “risk-free” or high risk. Respectively, this spectrum is from ultra-safe treasury bills to junk (“High Yield”) bonds. Do you chase yield in bonds or stocks?
Bonds, by their very nature, seem low risk compared to stocks. But is that true? It depends what you mean by risk.
When Low Risk is Actually High Risk
Say you cannot stomach volatility and are invested in 100% bonds. Here, the risk is not volatility, it is actually accomplishing your investing goals! You might never have enough to retire.
The Risk/Return Trade-off implies that a 100% bond portfolio has such “low risk” that you are at high risk of failure. Future expected returns must be considered. Stocks possess equity premiums—higher expected returns due to the volatility.
When High Risk is Actually Low Risk
On the flip side, why not invest in 100% equities? If you can stomach the volatility, this is actually the low-risk play. Young investors have no investment risk if they don’t sell low.
It all depends on your goals! Which, in turn, not infrequently depends on your age.
Chasing Yield for the Young
For instance, the young who dollar cost average into their retirement account have no investment risk as long as they won’t sell their “high risk” investments for decades.
For these folks, they should invest in assets that have the highest long term expected returns regardless of the volatility. Again, the risk is not volatility, it is panicking and selling low.
Risk location for the young can be a high-risk allocation (high stock to bond asset allocation). In addition, within the stock allocation, select asset sub-classes with higher expected future returns.
This includes ‘tilts’ such as small cap, value, emerging markets, real estate, momentum and the like. These have higher expected future returns because they are more volatile. For the young, volatility is not a risk (until it is!).
Let’s take this to the extreme. When young, why not leverage your stock investing? Invest in a 3x leveraged stock index fund??? No thanks, that’s too high risk for me. Here, volatility becomes risky, because enough of a downturn—even a temporary one—can unhinge these products from their indexes.
It is, however, common to take on mortgage debt. Mortgage debt is the same as owning negative bonds. That is, by having a mortgage and choosing to invest in stocks, you are leveraging your investing and taking more risk for the potential of more return. This risk seems more appropriate to take, as hopefully volatility is not correlated with your home price and your human capital.
What if you aren’t young anymore?
Chasing Yield during De-Accumulation
What about someone who is in de-accumulation? One spending down a portfolio has a very different risk profile. Here, instead of volatility, Sequence of Return Risk weighs heavily.
Sequence of Returns Risk implies a prolonged series of negative market returns while you are taking withdrawals. This sequence occurs early in retirement when the portfolio is the largest, and the downturn has the largest absolute affect.
Risk allocation for those in de-accumulation includes a more conservative portfolio. This allows you to take distributions from the bond portion of your assets when stock prices fall.
Having bonds also allows a longer horizon for equity exposure. Therefore, even a retiree very well may consider equity classes with higher future expected returns and more risk. As we see form the Callan table, there are different winners every year. Harvest from your winners and allow the downtrodden time to revert to the mean.
Thus, those in de-accumulation can take significant risk in the equity portion of their assets as well, as long as they have their overall asset allocation correct.
Are Bonds Low Risk?
So, fundamentally, here is the point: bonds are not low risk.
Or, more specifically, they are a poor risk/reward trade-off. The reward (Yield) is low, that you have to take too much risk to make the reward acceptable. Don’t chase yield in bonds! This could be either by going for high yield (junk) bonds, or by increasing the duration.
Chasing yield means attempting to get more money out of bonds by taking more risk. Bonds–or your “safe assets”- are not the location in your portfolio for risk.
If you need a higher return, increase your stock allocation rather than taking risk in your bond allocation!
Investment Risk Location and the Risk/Return Trade-off
So, the risk/return trade-off implies that risk location matters. Where to take investment risk? In the equity part of your portfolio, not in the bond part.
Remember: Investment risk for those with an appropriate asset allocation is not volatility.
Volatility is not the same as investment risk when you have your risk levels correct and understand the time considerations of risk/return.
Young folks have time. Older folks have bonds which buy them some time.
Looking at an asset allocation of bonds and stocks, where should you take the risk?
Don’t chase yield in your bonds. Bonds are for safety, and to dampen volatility. In the young, they improve investing hygiene (keep you from selling low). In those less young, they are pretty good to mitigate sequence of return risk. Bonds allow you time to take risk in stocks.