When Bear Market Comes, What is Riskier: Stocks or Corporate bonds?
Things are turning decidedly bearish in today’s investment world. The stock market’s volatility has many people wondering where their wealth is safest – in stocks or bonds.
Stocks fluctuate drastically, often by the hour. Bonds, on the other hand, generally promise safety in exchange for slower growth, and move in a negative correlation to the stock market.
The Correlation between Stocks and Bonds
Diversification is an essential risk-reduction tool for investors. It also helps to generate income. Bonds are generally touted as being an ideal way to offset risk from the stock market, because government bonds move inversely to the market (when the market rises, government bonds sink, and vice versa).
However, corporate bonds don’t work in this way. They move similarly to the stock market, but without the drastic peaks and troughs. So, what should you do in a bear market?
Corporate bonds, while tied to a company’s performance, won’t lose their value in the same way that stocks will. While there will be some decline, it will not be as significant, offering you some downside protection. Yes, that means that there is a risk here.
Does that mean bonds should be left alone? Not at all. It’s really all about your goals and the timeline on which you’re investing.
The Impact of Investment Timeline and Your Goals in a Bear Market
If you have a longer investment horizon, then it’s more important to stick with the correct asset allocation rather than trying to jump ship midstream. Timing the market is something that only short-term investors should worry about.
For instance, if you’re 25 years from retirement, you have more risk tolerance. Those closer to retirement have less, so the stability of bonds is better than the flash-in-the-pan growth of stocks.
The stock market is currently overvalued. In fact, many experts are pointing out that we’ve already hit peak valuation, and market performance will decline (turning it into a bear market).
For those who need to generate income due to their proximity to retirement, playing the market now is probably not a good idea, simply because you have less risk tolerance and need to be able to count on your investments to see you through your “golden years”.
To put it plainly, both stock and bond investors are at risk for capital loss.
Stock investors will lose capital when interest rates plummet. However, bond investors will lose interest when those rates rise.
Your ability to combat capital loss should be the yardstick by which you measure the value of both stocks and bonds, combined with knowledge of how the market will be moving tomorrow, next month, next year, and even farther out.
With all that being said, high-grade corporate bonds, such as from companies like Coca-Cola, GE, and UPS, held until maturity provides you with protection from both rising credit risk and interest rates, as well as protecting you from a bear market.
When you hold a bond until maturity, you protect your capital. You’ll get the full face value back when it matures. In the interim, you benefit from coupon payments, giving you a predictable stream of income that helps you make ends meet.
Obviously, this is an important consideration for those nearing retirement age, as well as those already in retirement.
How Much Risk Can You Take?
The question you shouldn’t be asking is, “Which one is riskier?” Instead, you should be asking, “How much risk can I handle?”
Ultimately, that’s the one that will help you see the most returns.
If you’re shy of risk at the moment—and again, remember the bear market that may be coming—it makes the most sense to go with bonds. You’ll still want to do all that research though and diversify your portfolio.
On the other hand, if you’re younger or just have the means to assume a bit more risk, then by all means, look into large well-established stocks or ETFs. Don’t become a cowboy, of course, but feel free to look where real opportunity may lie.
However, some studies suggest that millennials are much more risk averse than baby boomers and, based on their risk tolerance, equity allocation should be somewhere between 40%- 60%.
The one really nice thing about corporate bonds is that, if the company that issued them makes it through a bear market, you should have nothing to worry about. If you buy stocks, and the company fails, you’ve just lost that money. Even if they survive, it could be years and years before you’re lucky enough just to break even on your initial investment.