Risk, Return, and Portfolio Allocation: Why Stocks Are Less Risky Than Bonds in the Long Run
Risk, Return, and Portfolio Allocation: Why Stocks Are Less Risky Than Bonds in the Long Run
Summary of Chapter 2:
In the current article by Siegel J. J, the main idea explained is that the risk associated with the corporate bonds and the stocks is based on the market value in the future. The main focus of the article is on the lower risk levels long term investments in stocks as compared to the investments in the bonds. The techniques used in the article are analyzing the historical data and few statistical formulas such as correlation and the standard deviation. At the same time, the research done by the Siegel, the same figures shows that the bond investments are low risk on the basis of short term investments as compared to the stocks. However, in the basis of historical data, the investments in stocks for at least 17 years were more profitable than the overall inflation rate for the life of the investment. (Seigel, 2007)
The main reason is that the cash inflows in the bond investments are restricted to the interest income or yield and the return of the principle amount. After the maturity of the bond, the agreement between the entity and the lender finish according to the terms of the bond. However, in the last two decades, the floating bonds are reducing the risk of losses in the bond investments because according to the floating bond concept, the liability of the entity is measured according to the market value of the bond. (Seigel, 2007)
In most of the cases, the bonds are less expensive for the business and less risky for the investors. Therefore, the amount of interest rate or yield is the bond agreement is lower than the bank rates. During a long run, it is highly probable that at the end of the bond investment, the actual returns from the investment are lower than the market value of the bond. The market value of bonds and the stocks are an important element in the risk allocation for the investors. It is less risky for the stock investor, when an entity is declaring a dividend regularly on the annual basis. The declaration of the dividends on the regular basis shows that the entity is performing well and the performance of the entity is accumulated in the share price of the business. (Seigel, 2007)
Opinion:
On the basis of the methods and the data used in the article, the investor must use the tactics of selecting good investments in the portfolio. The performance management aspects of the entity will assist the investor in investing in the profitable stocks and bonds. However, according to the current business environment, it is recommended to incorporate the latest techniques and use the most recent historical data. Therefore, on the basis of research done in the article, in my opinion the methods used are acceptable except for the historical data analysis and the best possible tactic is to use portfolio and standard deviation on the current data. By using all the tactics and methods, the investor can match the outcomes and plan a proper investment portfolio.
The main disadvantage of using the methods used in the article is that it is highly probable that the data of the past years will be irrelevant for the current investors. Therefore, in these circumstances, it is the decision of the investor if he/she accepts the findings of the historical data and makes decisions on the basis of historical data.
Bond Prices and Yields:
When the business is performing well, then it is highly probable that the bond issued by the entity will be lower than the actual market rate because of the low level of risks in the entity and ultimately the investor will suffer loss in bonds in the long run. Moreover, the stocks also provide the opportunity of the capital gains on the selling of the shares. The selling and purchasing of the shares are easier than the selling of the bonds because of the less risky attributes of the stocks in the long run. With the help of active management and performance management techniques, the investor can improve the returns from the investments in the stocks in the long term. The principles of performance management are based on the portfolio techniques which can reduce the investment risk by diversifying the investment. (Bodie, 2014)
Equity Evaluation Models:
The investor must use the equity evaluation models such as dividend growth models to estimate the future growth in the stock investments. The policies of the companies and the plans for the future investments are the key signals for the investors to evaluate the equity’s future growth. Similarly, by analyzing the increase or decrease in the market value of the share, the investor can evaluate the future growth or decline in the share prices. (Bodie, 2014)
Active Management and Performance Measurement:
The performance management and the active management suggest that the investor must diversify his investments in the different companies and different sectors to reduce the risk of losses and increase the chances of dividend income and the capital gains. (Bodie, 2014)
In the case of bonds, the investor can utilize the performance management techniques if the bond is a convertible loan. In case of simple bond investment, the investor must follow the terms of the bond. Therefore, the flexibility of the stock investments makes the stocks less risky than the bonds. (Bodie, 2014)
Portfolio Management Techniques:
Siegel J. J also suggested that the investor must hold the proper portfolio of the investment, ideally the mixture of bonds and the stocks at the different level of risks. Therefore, it is important to analyze the performance and the active management of the business to create a proper portfolio of the investments. The main point in the performance management analysis of the portfolio is to analyze the performance of each entity in the portfolio and compare the performance with the prior year’s performance. If the performance in the current year is poor or unfavorable, then the investor must sell the stocks and purchase stocks in other profitable entity. If the investor is risk seeker, then the investor can analyze the results of the performance management according to the risk seeking attitude. (Seigel, 2007)
New Terms:
The new terms in the given article are correlation and the investment portfolio. The concept of correlation can be used to co-relate the independence and the dependence of risk and return or the investments. The concept of portfolio explains that the investor must diversify the investments to reduce the overall risk of the investment. Another new concept is the use of statistical formulas in the relation to the business decision making. For example, the standard deviation formula is applied in the different way to identify the dispersion between the actual risk and the level of risk acceptable for the investors or inflation rate. (Seigel, 2007)
References
Seigel, J. J. (2007). Stocks for the Long Run: The Definitive Guide to Financial Market Returns
and Long Term Investment Strategies (4th ed.). McGraw-Hill.
Bodie, Z., Kane, A., Marcus, A., Perrakis, S., & Ryan, P. (2014). Investments (8th ed.).
McGraw-Hill Ryerson.
