My writing over the years has shown the evidence that investing defensively puts the odds on your side… but low risk doesn’t mean no risk. No matter how safe an investment might seem on the surface, there is no such thing as an investment that bears zero risk.
Even parking savings in a bank account entails risk. And I’m not talking about the long-shot risk of a potential bank failure, but the very real risk that your money will lose purchasing power while it sits “safely” in a bank account. Mellody Hobson, president of Ariel Investments, says it best: “The biggest risk is not taking one.”
There is literally nowhere to hide from risk.
Let’s consider the humble bond. Bonds, in general, are not great investments.
The problem with bonds is that your upside is limited to the interest coupon. You’re never going to be pleasantly surprised by an investment in a bond. You either get exactly what you signed up for, or you get disappointed. I suppose that’s the price you pay for safety, but the safety itself is an illusion, particularly in periods of high inflation.
Same goes for hiding in bank savings accounts, certificates of deposit (CDs) or guaranteed investment certificates (GICs). You’ll get your principal back, but your ultimate purchasing power might be diminished. Do this over a lifetime, and you could see your wealth eroded by that stealthy thief, inflation.
For this reason, I see bonds and savings accounts as parking spots for money. Definitely not the cornerstone of a long term investment strategy.
The key here is to understand the difference between nominal and real returns.
You have a bond that pays 5 percent. That’s your nominal return.
Inflation during the period is 3 percent. So your real return is 2 percent (5 percent minus 3 percent).
You pay tax at 50 percent. So your after-tax bond coupon is 2.5 percent (half of 5 percent). Inflation was 3 percent, so your effective real after-tax return is minus 0.5 percent.
Some bond issues, like US municipal bonds, offer investors tax-free interest coupons. This is better, but the coupon rate on these will generally be lower, to reflect the tax-free nature of the interest receipts. Better, but still not great.
Unless your real return is high enough to compensate for your tax expense, bonds guarantee you a very low return—maybe even a negative return. This is not the cornerstone of a low-risk investment strategy. Indeed, if we define risk as losing purchasing power over time, it’s a strategy that almost ensures failure. The only way you possibly win is if future inflation comes in lower than expected.
Having said this, bonds are a necessary evil. They can be a stabilizing force in your portfolio, because they tend to hold value, or even increase in value, at times of market stress.
So while bonds suck, if you choose not to hold any, you will end up increasing the risk and volatility in your overall holdings.
What we need to do is build a portfolio that gives you just enough risk to get you where you want to go. Not too little. Not too much. We want to dial in that risk just right.
Your goal should be to build a portfolio that allows you to hold less of your assets in bonds while still minimizing volatility.
Building a more conservative equity portfolio allows you to do this. Instead of trying to minimize portfolio volatility, focus on buying the kind of businesses you’d love to own. These businesses tend to have less volatile stock prices and therefore benefit from the low-risk anomaly. Developing an understanding of which strategies work and which don’t will help you filter the noise and gain confidence in your portfolio.
My firm belief is that the world’s lowest risk investment isn’t cash. It isn’t government bonds. It isn’t savings accounts. Nor is it gold, or even real estate. It’s a diversified basket of conservative common stocks - a group of businesses that will endure whatever the future brings us.