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Why Stocks Look Safer Than Bonds Right Now

Warren Buffett says bonds appear riskier than stocks. He may be right.

By Chris Farrell | May 11, 2012
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Chris Farrell is economics editor for APM's Marketplace Money, a syndicated personal finance program.

The conventional wisdom says that stocks are riskier than bonds. That's a generally accepted idea supported by investment history. But the conventional wisdom seems off right now.

Risk in the financial markets is synonymous with volatility, sharp movements in an investment’s price that can be upsetting to the investor. An abrupt drop in stock prices can be terrible for, say, a parent planning to sell shares to pay college tuition or a retiree depending on stock sales to meet everyday expenses.
 
The reason stocks are considered more volatile than bonds is that investors don’t know whether the companies they invest in will earn a profit in the future. With bonds, they enjoy greater certainty of a payoff.

On the other hand, over time investors have been amply rewarded for taking on the risks associated with stock ownership. From 1926 through 2011, stocks clocked an average annual total return of 9.8 percent, while bonds returned 5.7 percent, according to Ibbotson Associates.
 
Buffett Says Bonds Are Riskier Now
 
Yet these days Warren Buffett, chief executive of the Berkshire Hathaway conglomerate and perhaps the greatest stock picker of all time, sees significant risk in bonds. In his latest annual letter to Berkshire Hathaway shareholders, he wrote: “Right now bonds should come with a warning label.”

So what’s safer than bonds? Stocks, Buffett says.
 
What gives? As we slowly emerge from the shadow of the Great Recession and the global credit crunch, is Buffett saying that our traditional notions of investment risk have been upended ?

Hardly. His insight is far more prosaic: When it comes to evaluating risk, timing matters.
 
Bonds Have Been Hot
 
In recent years, bonds have been on an incredible roll. From 2007 through 2011, long-term U.S. government bonds returned 10.7 percent, according to Ibbotson, while stocks lost money, producing a total return of -0.25 percent. (The total returns for bonds reflect the decline in interest rates and the rise in bond prices during that period.) Over the past decade, the compound annualized total return for bonds was 8.9 percent, compared with just 2.9 percent for stocks.
 
Little wonder that bonds have been so popular lately. Since the start of the recession, investors have poured $838 billion into bond mutual funds while withdrawing almost $400 billion from equity mutual funds, according to the Investment Company Institute, a Washington–based trade group.
 
Investors are so eager for the safety of U.S. Treasuries that now the federal government barely has to pay interest on them. The high demand means the government doesn't need to offer much to entice people. The yield on 10-year Treasuries, for example, currently hovers around 2.1 percent.
 
If the Economy Strengthens, Rates Will Rise
 
But here’s the thing: If the economic recovery gathers momentum, the prices of bonds are likely to fall and bond yields are likely to head higher. (When interest rates go up, bond prices go down; when interest rates drop, bond prices rise.)
 
Two factors push interest rates up when lenders and borrowers believe the future is getting brighter:
 
First, the demand for credit goes up, and strong demand enables suppliers of credit to charge more — a higher interest rate — for the use of their money.
 
The second reason rates rise when the economy improves is that the public’s inflation fears start growing, since companies feel freer to increase prices and workers start asking for pay raises.
 
“When the economy starts to grow again, people worry less about recession and more about the potential for inflation,” says James W. Paulsen, chief investment strategist at Wells Capital Management. “That could come out in rapid upward movements in bond yields, which means big downside price risk in your bond holdings.”
 
The Stock/Bond Seesaw
 
Here's the essential dynamic of the downward spiral Paulsen is describing: Investors will start demanding that new bonds reflect the higher yields in the marketplace. As a result, the price of the bonds people bought in recent years, when rates were lower, would fall — perhaps precipitously. (Eventually, investors will go back to buying bonds so they can pocket those higher rates, but only once it’s clear that inflation has been tamed.)
 
Meanwhile, the outlook for stocks should improve because corporate profits and business activity will pick up, the unemployment rate will drop, confident consumers will spend more, and companies will invest more.
 
A Time-Tested Insight to Remember
 
This assessment of the relative risks embedded in stocks and bonds isn’t a forecast of what equities and fixed income securities will do over the next week, month or year. It simply repeats a time-honored insight in finance: When everyone owns an investment — whether it's dot-com stocks or residential real estate — danger lurks. 
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