Let’s start with a parable.
Next to a mountain trail stood a twisted, gnarly tree. Hikers loved the shade it provided, but one day, a guy with an ax came along and decided the tree could do more than provide shade. He thought the tree would make a great table. So he chopped it down and hauled the tree to a carpenter.
Much to the man’s disappointment, the carpenter took one look at the tree and said, “This tree is too twisted and gnarly to be a table.” Now the hikers have no shade, the tree isn’t a table and the man with the ax is disappointed.
Investors make a similar mistake every time they try to make stocks feel safe like bonds or try to get bonds to generate big returns like stocks. Stocks, bonds and even cash are what they are. That doesn’t stop us from trying to change their nature though. More often than not, we end up disappointed because they fail to meet our expectations.
But is it really their fault? Or is it ours?
The closest thing we have to a universal rule in finance is that risk and expected return are related. Once we’ve got a diversified portfolio of investments, we must take greater risk to get a higher return. Risk is mainly a function of how wildly the investment you own fluctuates in value. In other words, in order to get a higher return, we need to deal with something going up and down. Sometimes a lot. That’s the deal we make with the markets, and there’s no real way around it. Every time I see someone trying to figure out a clever way to break this rule, it ends up breaking them.
Stocks, assuming you have a low-cost, broadly diversified stock portfolio, move up and down a lot in the short term, but offer the promise of growth in the long term. Bonds (the short-term, high-quality kind) provide a safe place (relatively speaking) to invest over a short period of time, but their returns barely keep up with the taxes you may pay on them plus inflation over longer periods of time. Cash gives us flexibility without much return.
If we understand the nature of stocks, bonds and cash and use them in a way that plays to their strengths, we can avoid a whole host of problems with our investing behavior.
In fact, once we understand the deal we’ve made with the markets, we start to realize that these wild swings are the reason we get paid to own stocks. Without those wild swings, the higher returns that stocks have delivered would go away, and all we’d be left with are certificates of deposit at the local bank. No risk there, so no reward.
We can’t unbundle risk and return, but I keep seeing people giving it their best shot.
The classic examples include things like trying to time the market (e.g., get out before stocks drop) or investing in clever financial products that promise “equity-like returns with half the risk” or products marketed as “just like a certificate of deposit, but twice the return.” Look, stocks are stocks, bonds are bonds, and cash is cash. The minute we set an expectation for them to break this trade of risk for return, we’re setting ourselves up to be disappointed.
A lot of our bad investing behavior comes from these unrealistic expectations. We’re shocked when the market goes down 20 or 30 percent, even though that is part of the deal. So, we start looking for a safe alternative to the low interest rates we’re earning on our savings accounts. We buy some new product marketed to retirees as a way to get higher income without all the risk. Then, we end up owning a junk-bond portfolio that gets crushed the next time the markets change. Whatever the bad decision, it often stems from believing we can change the nature of this deal we’ve made with the markets.
Over the last 30 years, stocks have returned, on average, around 10 percent. Bonds have returned roughly 5 percent. These are facts, yet we insist we have the power to change reality. It’s the investing version of trying to make a square peg fit in a round hole.
Like the tree that provided shade for hikers, we have investment options that play a very specific role in our overall financial strategy. The best part is that once we accept them for what they are, we can use them to help us reach our goals without disappointment or frustration. We don’t need stocks or bonds to be something they aren’t once we understand exactly what they can do.
This commentary originally appeared April 14 on NYTimes.com
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