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Dr. Contrarian: Why Mixing Bonds and CDs With Stocks Actually Increases Your Risk

Moti Levi

Warning: If you are a financial adviser, financial planner or another type of "consulted one," the following article might pose a risk to your health. By reading further, you agree that the author is not liable for any symptoms or problems you may have due to your response to this article, and you bear full responsibility to all such.

When you hire a financial adviser or planner to get advice and plan your investments, they uniformly start by understanding your risk preferences and attitudes.

After gauging your risk attitude, they provide you with investment portfolio recommendations to match your risk profile. The matching is accomplished by using different classes of investments , each supposedly representing a different risk and return profile.

While there are many classes, let's simplify by assuming there are only stocks (mutual funds included), bonds and CDs , which are the main ones used. The main idea behind mixing of these classes is that bonds and CDs supposedly lower the risk presented by stocks.

Why supposedly? Don't bonds and CDs have a different (lower) risk profile than stocks? After all, bonds and CDs offer a guaranteed return and as such, are not "risky," right?

The answer is yes and no. Yes, bonds (only if held to maturation ) and CDs do offer a guaranteed return. No, they don't lower a portfolio's risk.

Bonds and CDs Don't Do What?!

Let's revisit the reason for recommending stocks in the first place. The argument for investing in stocks is that over the long run of 25 years or so, stocks perform the best (and pretty regularly so). This is based on taking chunks of 25 years and measuring what a stock's index or (or "big basket" of related stocks) would have done over the course of that period.

The research shows that, basically, regardless of when the 25-year period takes place, stock returns average about 10.4% (different figures are quoted for different baskets but the point is the same). Therefore, it is argued, if you invest in stocks for the long run, you'd see such returns despite short-term volatility .

If we buy this, we tell our adviser, "Go ahead, invest my money in stocks."

"Wait," he says, "you have to balance the "risk" (what he really means is "volatility") with some low-risk investments, such as bonds or CDs. You agree, thinking you don't want all this up and down movement in your portfolio.

About Bonds

Let's forget that bonds are very volatile in the short term. In fact, more so than stocks, because bonds are all affected by similar factors, such as interest rates. To avoid this short-term volatility, let's assume you hold the bond to maturity.

CDs are not a problem, as they do provide a guaranteed return. In fact, the return on CDs is so guaranteed, it promises to not leave you with much after you take into account inflation and taxes. It is the same situation for long-term bonds.

Wonderful, isn't it? The more money you put into CDs and bonds, the lower your return will be. Guaranteed.

More Money In, Less Money Back? Here's an Illustration

I'm going to keep this very simple, so if you are into math models, don't shout. We can exchange exotic distributions in our spare time. For now, let's keep it simple.

Let's say the expected return on your stock portfolio is 10% and there is a 10% chance it will be below 8%, which is the (lowest possible) return you need to receive in order to have what you need in your retirement. Now say your bonds or CDs give you 5% risk-free. If you keep your portfolio at 100% stocks, you face 10% of not making it (an 8% return). Not bad odds. But if you keep all of your invested money in bonds and/or CDs, you face 100% chance of not making it.

Therefore, as you move money (see capital ) from stocks to bonds/CDs, you increase the chance you that will not make your desired 8% return.

Plus, to achieve this you have to freeze your money in bonds (the trading alternative: short-term volatility and high risk) or CDs (the longer the term, the better the return). Therefore, you reduce your short-term liquidity . This means you increase your short-term risk, not reduce it.

So when it comes to investing, what you're really concerned about is not "volatility," but whether or not you'll "have what you need and want, when you need want it."