On Wall Street, the standard saying is “risk follows returns.” By choosing a lower risk investment (such as U.S. Treasury Bonds), you will receive a lower return. Treasury Bonds are considered the safest investment possible because the U.S. has always paid those bonds back (except for debts from the Revolutionary and Civil Wars, but that’s another story). Almost all long-term interest rates are influenced by the rate on the U.S. Treasury Bonds, which are considered a “risk-free” return.
In terms of risk, the three traditional investment instruments are stocks,
bonds, and cash. We can analyze each in terms of risks and rewards. On Wall Street, risk is measured by beta (the Greek letter β), which measures the volatility or deviation from the average historical return of an investment.
Stock prices are negatively correlated with recessions. Below, you can see a chart showing the prices and volatility of the general stock market. The grey bars are recessions, so it is easy to see their impact on the stock market. The S&P 500 is a general index of the overall stock market. It was created and is maintained by the financial company Standard and Poors, which is a major credit rating company. The index consists of the prices of 500 stocks out of the 3,700 public companies listed on American stock exchanges, and the composition of these 500 selected companies reflects the composition of the entire market.
Figure 13.1. S&P 500 Daily Closes and Recessions by Fred Rowland is used under a CC BY-NC 4.0 License. Source: Yahoo Finance data (12/3/2020).
Adding bonds tends to lower both risk and potential return. The following chart shows the maximum gains and losses on various portfolios consisting of all stocks (on the left) through a series of mixed stocks and bonds to a portfolio consisting of all bonds (on the right). As you can see the maximum gains and losses are greatest with an all stock portfolio.
Figure 13.2. Best Annual Gain and Worst Annual Lost by Fred Rowland is used under a CC BY-NC 4.0 License. Source: Vanguard data.
Finally, some investment advisors suggest you should hold up to 10% cash in your portfolio, either for emergencies or to take advantage of bargains that may arise in the market. This should not be kept in a checking account but in a money market fund. The current annual return on money market funds is 1.7% (Vanguard Prime Money Market Fund).