Do You Look at the Risk-Reward Ratio of Your Stocks and Bonds?
By Douglas Goldstein CFP® - helping olim handle their U.S. investments from Israel
The risk-reward ratio is an attempt to quantify the amount of risk you need to take in order to get an anticipated return from any investment.
If you were to only consider past returns when deciding whether to invest in stocks or bonds, stocks would appear to be the clear winner. From 2007 to 2016, stocks had an average annual return of 9% versus about 5% for 10-year U.S. Treasury bonds.
If past returns are your only measurement of performance, then perhaps you should consider high-yield corporate bonds. This year, Harvard University’s endowment fund made its largest allocation to a high-yield corporate bond exchange traded fund (ETF), which had a one-year return (through March 2017) of 13.4%.
Risk vs return
Prudent investors know that past performance is not a guarantee of future returns, and instead of chasing last year’s returns they start by looking at their own risk profile. Indeed, some would say that Harvard marched farther out on the risk spectrum than a conservative education endowment should wander.
Fund managers always look at both the return and risk premium – the risk-adjusted return – of a stock or bond. The risk premium is one of the most important metrics in investing because it indicates how much money you may receive (the return) for the level of risk taken.
So, do stocks still make sense?
Stocks make a lot of sense on a risk-return basis. Looking over a long investment horizon, from 1967 to 2016, stocks returned over 11% on average compared to about 7% for 10-year U.S. Treasury bonds. Consider too, that stocks’ risk premium was 6.6% and the Treasuries’ 4.4%. By comparing the risk-return metrics, it appears as if investors are taking on added risk in exchange for incremental stock returns.
Diversifying an investment portfolio by adding bonds with a lower risk-return ratio may provide a superior risk-adjusted return. Find out why having a diversified portfolio matters at Profile-Financial.com/asset-allocation
Douglas Goldstein, CFP®, is the director of Profile Investment Services, Ltd. www.profile-financial.com. He is a licensed financial professional both in the U.S. and Israel. Call (02) 624-2788 for a consultation about handling your U.S. investments from Israel. Securities offered through Portfolio Resources Group, Inc. Member FINRA, SIPC, MSRB, FSI. The opinions expressed are those of the author and not those of Portfolio Resources Group, Inc. or its affiliates. Neither PRG nor its affiliates give tax or legal advice.