The tradeoff between investment risk and reward (or potential return) is one that every investor needs to decide individually. That balance will likely change depending on the investor’s goals, circumstances, and age. But many investors seek a balance between risk and reward by hedging their portfolio allocation according to their risk appetite. For example, the traditional 60/40 portfolio consists of sixty percent equities and forty percent fixed-income instruments, like bonds. The stocks typically offer a more significant opportunity for growth but carry the risk of loss. In contrast, the bonds provide a smaller potential value increase and often less volatility. In theory, the stocks offer growth over the long term, while the fixed income holdings provide a hedge to help manage exposure to periodic value drops.
How well do balanced portfolios manage risk?
Over the last ninety-plus years, a 60/40 portfolio has returned an average of nine percent. Since the Great Financial Crisis (2008), the outcome has been even more positive, with an average since that event of 11.5 percent.1 However, out of the last forty years, investors have experienced decreases of more than ten percent nine times. It's helpful to note that in five of those nine downturns, the portfolio returns recovered within the year, and in three more, they regained more than the lost value the following year.
Why are fixed-income investments safer?
Fixed-income investments are regarded as lower risk because they seek to pay a set return (based on the coupon rate) on the invested amount, and the return is known in advance. Fixed-income investments are usually bonds, but various categories have different returns and risks. Governments and corporations issue bonds to raise capital and pay investors interest in return. Most bonds have fixed interest rates and specific end dates, but some have variable rates and may be perpetual.
If the issuing entity has excellent credit, it can pay a lower interest rate because they are less likely to default on the bond. Treasury bonds, savings bonds, and Treasury bills are backed by the full faith and credit of the U.S. government. These will have lower interest rates than a bond offered by a corporation that may not be as secure. A bond offered by a company with a lower credit rating may be referred to as "high-yield," which also connotes its higher risk.
- U.S. Treasury Bills are short-term (from a few days to a year)
- U.S. Treasury Notes mature within ten years
- U.S. Treasury Bonds typically mature in 30 years but pay interest every six months
- TIPS are Treasury Inflation-Protected Securities that may have maturity dates between five and thirty years and pay interest twice yearly. However, the capital amount for these bonds adjusts when the Consumer Price Index changes.
States and local governments may issue general obligation bonds, which they can repay with taxes, or revenue bonds that they repay with funds from a specific source like a sports stadium or a highway.
Do bonds have risks?
Aside from the chance of default, which depends on the issuer's creditworthiness, bonds have other risks. For example, if the bond pays interest lower than the current inflation rate, the investor is not earning enough to keep up and may lose purchasing power. There is also liquidity risk if the investor can't find a buyer if they want to sell the bond before it reaches maturity. Finally, bonds also carry a call risk, which means that the issue can retire a bond before it matures (for example, if interest rates decline), in which case the investor must reinvest the principal.
1JP Morgan Asset Management, Meera Pandit. “Is the 60/40 dead?” July 20, 2022
This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. It should also not be construed as advice meeting the particular investment needs of any investor.
Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation.
Risk tolerance is an investor’s general ability to withstand risk inherent in investing. There is no guarantee a recommended portfolio will accurately reflect your tolerance to risk.
All investments have an inherent level of risk. The value of your investment will fluctuate with the value of the underlying investments. You could receive back less than you initially invested and there is no guarantee that you will receive any income.
A bond's yield, share price and total return can change daily and are based on changes in interest rates, market conditions, economic and political news, and the quality and maturity of its investments. In general, bond prices fall when interest rates rise and vice versa. Past performance is not a guarantee or indication of future results.