Stocks vs. Bonds – How Much to Allocate to Each?
In the 1970s, structuring portfolios was much simpler, often following a straightforward “60/40” rule – 60% equities and 40% bonds.
Most US investors stuck to domestic stocks and bonds, trusting that this approach provided sufficient diversification.
The idea was that equities would drive growth in the portfolio, while bonds would offer stability and income.
Fast forward to today, and things have changed dramatically.
There are now an overwhelming array of choices, and the emphasis on getting asset allocation right, and the precise “engineering” of the portfolio, has grown significantly.
As a result, entire teams and departments are now devoted to making asset allocation decisions.
Their job is to determine how to divide investments among various asset classes, which involves answering questions like:
- What proportion should go into equities versus debt?
- How much should go into traditional stocks and bonds versus alternative assets?
- How should the portfolio be balanced between public securities and private investments?
- What portion should be allocated to domestic assets, and how much should go overseas?
- Within international investments, how should the allocation differ between developed and emerging markets?
- What’s the right balance between high-quality, lower-risk assets and more volatile, high-beta investments?
- Should leverage be used, and if so, to what degree and to what parts of the portfolio?
- How much should go into “real” assets like cash-flowing real estate and infrastructure?
- What role, if any, should derivatives (e.g., options) play?
We’ll cover the subject in detail in this article.
Key Takeaways – Stocks vs. Bonds
- Fundamentally, you might say there are only two primary asset classes: ownership and debt.
- These two asset types differ dramatically in nature.
- The combination of ownership and debt assets is essential for positioning your portfolio appropriately along the risk/return continuum. This is the most important decision in portfolio management and asset allocation.
- The other decisions, such as specific asset choices or manager selections, are about implementation.
- Your asset allocation will also be shaped by your ability to identify and access superior strategies and managers, recognizing that doing so is no easy task.
The Role of Computer Models
The sheer number of decisions can be overwhelming, and many traders/investors use computer models to guide them.
These models require assumptions about expected returns, risks, and correlations between asset classes, which are often based on historical data.
These historical inputs may nonetheless not be reliable indicators for future market behavior.
In particular, predicting the correlation between different asset classes is notoriously difficult.
Correlations change. As such, understanding how assets are driven becomes most important.
Done poorly, these won’t model future reality well, even if the mathematical models provide a sense of comfort through their technical rigor.
Differences Between Ownership and Debt
The relative appeal of stocks vs. bonds depends on the risk premiums between them.
If a safe bond gives you 5% and stocks are trading at a 20x forward P/E (the inverse is the yield), an asset allocator might prefer the safe 5% over the 5% with more variance to it.
As such, as interest rates shift, you might also think about the core difference between equity investments and credit.
While there are other asset classes (e.g., commodities, currencies, cryptocurrencies) you might simply think that there are essentially only two asset classes: ownership and debt.
If someone wants to participate in a business financially, their choice boils down to either owning a part of it or lending money to it.
Yield to maturity of a bond can be known based on its interest rate, maturity, and market price.
Unlike the equity side, where future returns have a lot of variance to them, bonds offer a clearer, calculable return if held to maturity, assuming the borrower made the promised payments.
This difference between stocks and bonds isn’t just a matter of degree – it’s a fundamental difference in kind.
Stocks represent ownership, which carries risk without any promise of return.
Owners receive a proportional share of whatever remains after all obligations, including payments to employees, suppliers, landlords, tax authorities, and lenders, are met.
If there’s anything left, it’s considered profit or cash flow, and owners may benefit from this residual.
On the other hand, lenders, such as bondholders, aren’t exposed to the same risk.
They provide capital to help businesses operate in exchange for a contractual promise of periodic interest payments and the return of principal at the bond’s maturity.
This kind of investment is often called “fixed income” because the payments are fixed.
But it’s closer to the concept of “fixed outcome” where the return is predefined and predictable – assuming the borrower doesn’t default.
Ultimately, equity and debt investments are fundamentally different.
Equity represents ownership, with all the risks and potential rewards that come with it, while debt is a contractual agreement with predetermined returns.
Understanding this distinction is one of the most essential decisions an investor must make when constructing a portfolio.
The Choice Between Stocks and Bonds
The next important question is: how should those decisions be approached?
What framework can guide us in making them?
Often the most important decision in portfolio management, the one that underpins all others, is the selection of the portfolio’s targeted risk exposure.
This involves determining the balance between aggressiveness and defensiveness.
Essentially, the critical question is how much emphasis should be placed on preserving capital versus growing it.
It’s ultimately a trade-off.
If the primary focus is on preserving capital or reducing volatility, the portfolio will lean toward a defensive stance.
This naturally limits the potential for high growth, as growth often requires taking on more risk.
On the other hand, if the goal is to maximize growth, the portfolio must take a more aggressive stance, which means that preservation of capital and portfolio stability must be sacrificed to some extent.
All other questions regarding asset allocation, such as the balance between stocks and bonds or domestic versus international investments, are secondary considerations that help to achieve the desired risk exposure.
When thinking about portfolio construction in these terms, it becomes clear that the aim should be optimization, not maximization.
The goal should not simply be the pursuit of maximum wealth, but rather the pursuit of wealth in a way that aligns with personal goals, needs, and risk tolerance.
A common misconception is that the primary objective in trading/investing is to achieve the highest possible return.
However, more sophisticated traders/investors recognize that the true goal is to achieve the best balance between risk and return.
By focusing on this balance, they can shoot for an allocation whose expected returns are sufficient to compensate for the risks involved, leading to a portfolio with a potentially attractive risk-adjusted return.
However, achieving a favorable risk-adjusted return is only part of the equation.
It’s equally important that the overall level of risk in the portfolio is consciously managed and not just an accidental byproduct of the asset allocation process.
The level of risk should be an intentional choice, aligned with the trader or investor’s objectives and risk tolerance.
In fact, one can argue that the absolute level of risk in a portfolio is the most critical consideration in portfolio management.
For any trading or investment strategy to be successful, the risk must be properly compensated, and the overall risk exposure must fall within the trader/investor’s desired range – neither too much nor too little.
Shape of the Curves
Probability distributions are best to illustrate the fundamental differences between potential returns from ownership assets, such as stocks or real estate, and debt instruments, commonly referred to as “fixed income” or “credit.”
To help explain this, we’ll first describe the general shape of the curve that represents the potential return on a portfolio of ownership assets.
Stocks Return vs. Risk Probability Distribution
Ownership assets typically offer a higher expected return, meaning they have more upside potential but also greater downside risk.
On the other hand, the curve for debt portfolios, which you’ll see in below, looks quite different.
Debt instruments generally provide a lower expected return, but that return falls within a much narrower range.
Bonds Return vs. Risk Probability Distribution
There’s minimal upside in debt – if you purchase a bond yielding 8%, you shouldn’t expect more than 8% per year over the long run.
The return is fairly predictable, as long as the borrower doesn’t default.
However, the downside is also limited since, in most cases, you’ll receive your principal and interest as long as the borrower makes payments.
This contrast between ownership assets and debt highlights a key difference in investing strategies: offense is usually better suited for ownership assets, where growth and upside potential are the main focus, while defense is better suited for debt, where stability and capital preservation take priority.
Of course, trading and investing doesn’t involve either/or decisions.
Most portfolios combine ownership and debt, with the key decision being how to strike the right balance between the two.
From 2009 through 2021, a period characterized by historically low interest rates, the expected returns on debt were extremely low – both in absolute terms and compared to the historical returns on equities.
This made debt relatively unattractive (shown below), as it offered far less reward for taking on risk compared to equities.
Probability Distribution of Stocks vs. Bonds Returns
However, in higher rate environments it can look quite different.
When interest rates rise, the expected returns on debt have improved significantly, bringing them closer to those of equities.
This shift is a major reason why equities tend to not perform as strong as interest rates rise.
The relationship between the potential return curves of ownership assets and debt at any given point in time should directly inform how market participants’ approach asset allocation.
When debt offers a more competitive return relative to equities, it naturally becomes a more attractive option in a balanced portfolio.
Now, the question arises: which is “better,” ownership or debt? The truth is, there’s no definitive answer.
In any reasonably efficient market, the choice is simply a trade-off between risk and reward.
Ownership assets offer the possibility of a higher return and more upside, but with greater uncertainty, volatility, and downside risk.
On the other hand, debt provides a more dependable but lower expected return, with less upside and less downside risk.
Ultimately, the choice between ownership and debt depends on the individual.
The “better” option isn’t universal; it’s subjective, based on the investor’s personal circumstances, financial goals, and tolerance for risk.
For some, the potential growth of ownership assets is worth the extra risk, while for others, the predictability and stability of debt may be more appealing.
Thus, the ideal balance between ownership and debt will differ from one investor to another.
Stocks vs. Bonds vs. Something in Between
You can take the curves representing the potential returns of ownership assets and debt and add two intermediate curves.
These new curves illustrate portfolios with varying combinations of debt and ownership assets.
You can think of one of the intermediate curves (blue) representing a portfolio with two-thirds debt and one-third ownership, while the other (green) represents one-third debt and two-thirds ownership.
Choosing the Offense/Defense Balance
Every trader, investor, or their investment manager should begin by identifying the appropriate “normal” risk posture, or the ideal balance between offense (growth) and defense (capital preservation).
This decision should be shaped by several key factors: their time horizon, financial situation, income, goals, responsibilities, and, importantly, their risk tolerance.
Once a trader/investor has established the right risk exposure for themselves, they face a choice.
They can maintain this exposure consistently, regardless of market conditions, or they can adjust it periodically based on market movements.
This means shifting toward offense (more risk) when markets are down and opportunities are more attractive, and shifting toward defense (less risk) when markets are riding high and risks are elevated.
Whether an investor chooses to keep their risk exposure constant or adjust it over time, the next critical question is how they implement that posture.
This brings us to an important concept: the relationship between risk and return.
This is a well-known graphic:
The traditional model shows that as we take on more risk going from cash to forms of ownership (moving from left to right on the graph), the expected return also increases.
However, this representation overly simplistic. The linearity of the graph suggests that increased risk always leads to increased returns, which contradicts the actual nature of risk.
In reality, risk doesn’t guarantee reward – it introduces unknowns, and this is where the traditional graph falls short.
To address this, we can represent the range of returns for increasingly riskier portfolios.
These curves illustrate that as risk increases, the range of possible outcomes widens, and the potential for negative outcomes becomes more severe and stretches further into undesirable territory.
This representation may make the trade-offs between risk and return clearer and more intuitive for traders and investors.
The center line becomes only a mean expectation with increasing variance the greater the risk taken.
For someone who strictly adheres to the belief that “more risk equals more return,” it would make sense to adopt a high-risk exposure.
However, if they fully grasp the implications of increased risk they may reconsider and choose a more moderate approach.
Understanding that with greater risk comes not only the possibility of higher returns but also a wider range of uncertain outcomes, including significant losses, may lead a trader/investor to opt for a balanced portfolio that better aligns with their personal risk tolerance and long-term goals.
This is the essence of risk: while the expected return may increase with greater risk, so does the likelihood of bad outcomes.
The Role of Alpha and Beta
The analysis above operates on the assumption that markets are efficient.
In an efficient market, the relationship between risk and return is proportional.
To put it another way: as expected returns increase, the accompanying risk (the uncertainty and potential for loss) also rises.
This means that no position on the risk spectrum is inherently “better” than any other.
It’s simply a matter of where a trader or investor wants to position themselves in terms of risk and the absolute return they aim to achieve.
The risk-return trade-off remains consistent along the continuum: less risk and return on the left side, and more risk and return on the right.
Moreover, at any point along this risk spectrum, the distribution of possible outcomes – both upside and downside – remains symmetrical around the expected return. This suggests that the balance between upside potential and downside risk is relatively the same at all levels of risk.
Market participants can move further out on the risk continuum in two ways:
- by either investing in riskier assets or
- applying leverage to magnify both potential return and risk
In a fully efficient market, neither approach offers an advantage over the other.
These principles highlight key implications of market efficiency.
In an efficient market, the only thing that truly matters is determining the right risk position for the investor.
At any given level of risk, there’s no additional return to be gained from choosing one approach over another.
The rationale behind this stems from the academic view that, in an efficient market, all assets are fairly priced relative to one another.
Therefore, there are no bargains or overpriced assets to exploit.
Moreover, this perspective holds that there’s no such thing as “alpha,” or gains resulting from superior individual skill.
As a result, active decision-making – whether in terms of asset class, strategy, security selection, or manager choice – doesn’t yield better results. It’s simply a matter of differing risk and corresponding return.
Of course, if you’re a trader, you probably don’t believe this to be true. Informational, analytical, and technological edges do exist.
But for those below a certain level of sophistication, the efficient market hypothesis is a good starting point.
In the academic view, since alpha doesn’t exist, the only thing that differentiates assets is their “beta,” or volatility relative to the market.
The expected return is proportional to beta.
Markets are nonetheless not efficient in the academic sense of always being “right.”
While markets may efficiently incorporate new information and reflect the prevailing consensus about prices, that consensus can often be far from correct.
This creates opportunities for traders and investors to generate gains by skillfully selecting among various investment options:
- Some assets, markets, or strategies may offer better risk/reward profiles than others.
- Certain managers may excel at delivering superior risk-adjusted returns within specific markets or strategies.
This raises an important question for asset allocation: should traders depart from their usual risk exposure to pursue a riskier asset class managed by someone believed to possess alpha?
The answer is not simple, especially since many managers thought to have alpha ultimately fail to deliver.
Conclusion
Portfolio management fundamentally revolves around the allocation between two primary asset classes: ownership and debt.
These two asset types are inherently different in nature, with ownership offering higher growth potential at greater risk, while debt provides more stability with predictable returns.
Striking the right balance between these assets is important to positioning your portfolio along the risk/return continuum.
Other factors, such as selecting specific assets, securities, or managers, have a secondary role, which is about the execution of this core strategy.
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