No matter what your goals are as an investor—retirement saving, income, college planning, spending money, or bragging about investing—one of the most critical decisions you have to make is where to put your money. The two most common investments for beginners are stocks and bonds. How do you decide what to buy?
One way is to look at how stock and bond performance compares over time. The chart below shows the annual returns of stocks represented by the S&P 500 and Baa-rated corporate bonds since 1928.
- You can use a balance of stocks and bonds to create a portfolio that gives you better returns than average.
- Your tolerance for risk and your desire for reward dictate how you should invest and what you should invest in.
- Using an investment's beta, standard deviation, charts, and the Sharpe ratio, you can judge whether an asset will give the best returns for your goals.
Are Annual Returns a Good Measure?
The years that stocks outperformed bonds are in blue, and the years that bonds outperformed stocks are in orange. The chart is an ocean of blue. It would seem that investing in stocks is an easy choice—why would anyone invest in bonds? As it turns out, performance is only one measure for successful investing.
How you invest has a lot to do with how much time you have before you need the money. If you are in the early to middle part of your career and invest for retirement, your time horizon is probably more than 10 years. On the other hand, if you are an active trader, you are looking for profits in a matter of days or weeks.
The following chart shows rolling 10-year returns from 1938-2019 for the performance of stocks compared to bonds. Rolling 10-year returns for each year represents the annualized return for the previous 10 years. For example, 1950 represents the 10-year annualized return from 1940 to 1950.
Notice the difference: Looking at 10-year results, they are "smoother" than annual results, and bonds look more attractive. Also, notice that the only negative years for stocks during any of the 80 rolling 10-year periods are 1938 through 1940, which reflect the lingering impact of the Great Depression. There are 19 individual negative years for stocks in the same period, by comparison.
This also illustrates how balancing your stockholdings with some stability from bond ownership in a portfolio can provide a hedge for potentially volatile swings in stock prices.
How Much Risk Can You Tolerate?
There's more to your investment decisions than just performance. How much risk are you willing to take? The 2020 financial roller coaster is a case in point. It took only about four weeks for the market to lose 32% of its value, plunging from the S&P record high of 3,358 points on Feb. 12 to 2,447 at the close on March 18, with wild swings along the way. The good news is that the S&P had recovered nearly all its losses as of mid-August.
If your time frame is short or volatile markets like we saw in 2020 keep you up at night, you have to consider that in your decisions.
The fact is that the average retail investor consistently underperforms the market, especially when the markets are unstable.
Measuring Risk and Return
Two common ways to measure the risk of an investment are its beta and standard deviation. Beta measures an investment’s sensitivity to market movements, its risk relative to the entire market. A beta of greater than 1.0 means the investment is more volatile than the market as a whole. A beta of less than 1.0 means the investment is less volatile than the market.
Standard deviation measures the volatility of the investment. A lower standard deviation means more consistent returns. An asset has a higher risk if there is a higher standard deviation, which means less consistent returns.
The chart below shows an example of the beta, standard deviation, returns for an S&P 500 index fund, a bond index fund, and a fund that strictly invests in smaller companies.
|Beta||Standard Deviation||3-Yr Return|
|S&P 500 Index Fund||1.0||16.95||10.71%|
|U.S. Bond Fund Index Fund||1.0||3.32||5.23%|
|U.S. Small Cap Fund||1.17||27.69||12.5%|
Notice that the beta for the S&P index fund and the bond index fund is 1.0. That's because those funds represent each broad market for stocks and bonds. Also, notice the beta for the small-capitalization fund is 1.17, which indicates that this fund is more volatile than the overall market represented by its benchmark, the Russell 2000 growth.
No surprises here—the bond fund has a much lower standard deviation, less risk, and offers less return.
How the Sharpe Ratio Can Help You Value Risk
How do you determine if you're being paid fairly for the risk you are taking with an investment? There is a measure called the Sharpe ratio, which compares the standard deviation against the returns. If an asset has high volatility with low returns, the Sharpe ratio will reflect that. A Sharpe ratio of 1 or more is the goal. Here are the Sharpe ratios for the S&P index fund, the bond fund, and a fund that invests only in large-cap growth companies.
|Sharpe Ratio||3-Yr Return|
|S&P 500 Index Fund||0.53||10.71%|
|U.S. Bond Index Fund||1.11||5.23%|
|U.S. Growth Fund||1.24||26.94%|
Notice the Sharpe ratio for the S&P 500 index fund versus the growth fund and bond index fund. The S&P 500 index fund is not rewarding you relative to the risk you are taking compared to the growth and bond index funds.
How to Use Asset Allocation
Asset allocation is the process of deciding how much of your money you should put into stocks, bonds, cash, and perhaps other investments like real estate or commodities to achieve the best return for your risk tolerance.
Whether you are a conservative investor or someone who wants to roll the dice, the "big idea" behind managing your investments is to get the best return for the risk that you are willing to take.
Broker-dealers like T.D. Ameritrade and mutual fund companies such as T. Rowe Price and Fidelity, along with others, offer model portfolio products with pre-determined allocations. Allocation models are typically billed as conservative, moderate, or aggressive. These prepackaged funds are an easy way for investors to create portfolios aligned with their time frames and risk profile.
The Bottom Line
Using tools like standard deviation, beta, Sharpe ratios, and illustrations like rolling 10-year returns can help any investor make smarter decisions about their portfolio and seek the best return for the risk they are willing to take.
The average retail investor consistently underperforms the market. They make less in the good years and lose more in the bad years. But you don’t have to be the average investor. Be honest with yourself about how much risk is comfortable for you. Don't chase returns, and unless you're an active trader, take a longer view.
There are plenty of educational resources about personal investing available from the regulatory agencies like the federal government's information site (Investor.gov), the Financial Industry Regulatory Authority (FINRA), and The Securities and Exchange Commission (SEC), as well as from the financial services industry.
If you are new to investing or don't have the time to do your own research, consider working with a professional financial adviser.
The Balance does not provide tax, investment, or financial services, and advice. The information is being presented without consideration of the investment objectives, risk tolerance, or financial circumstances of any specific investor and might not be suitable for all investors. Past performance is not indicative of future results. Investing involves risk including the possible loss of principal.