What should people do with their savings? That is the question that beguiles so many of us today. As a saver, you are faced with many different possibilities. One option is to put your hard-earned cash into a savings account. Unfortunately, the ultra-low interest rates that have come to dominate the financial landscape over the last decade have made it impossible to build a good retirement pot by parking your cash in a simple savings account.
Fortunately, there are other ways for average people to invest their money. But what should they buy? What should be the relative weighting of equities to bonds? The conventional wisdom is that stocks represent a riskier investment than bonds, but is this actually true? In his 2014 letter to shareholders of Berkshire Hathaway BRK.ABRK.B, Warren Buffett (Trades, Portfolio) explained why, in the grand scheme of things, stocks are a less risky investment than bonds.
Volatility is not risk
The core of Buffett’s thesis reads thus: the U.S. dollar has depreciated substantially over the course of the last 50 years. Meanwhile, the capitalization of the U.S. stock market has grown immensely:
“During the 1964-2014 period, the S&P 500 rose from 84 to 2,059, which, with reinvested dividends, generated the overall return of 11,196% shown on page 2. Concurrently, the purchasing power of the dollar declined a staggering 87%. That decrease means that it now takes $1 to buy what could be bought for 13¢ in 1965 (as measured by the Consumer Price Index).”
The income that an investor receives from U.S. Treasuries is denominated in U.S. dollars. If the value of the American currency declines in value, then the value of the payouts from holding bonds will fall over the same period. From this simple observation, Buffett draws the conclusion that over the last five decades, stocks have been a much safer investment proposition than bonds.
This begs the question: why do people think that stocks are riskier than bonds? The answer is volatility; the fluctuation of the total returns that investors get from stocks:
“Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.”
The central problem that seems to confuse so many people is they mix up risk and volatility. Yes, the returns from stock investments do fluctuate a lot more than the returns from bonds (which are, by definition, almost always fixed). But volatility is not risk. Short-term fluctuations in the price of assets do not diminish the intrinsic value of those assets.
In the next part of this series, we will explore why this is so.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Buffett and Munger: Cultivate Curiosity and Mental DisciplineÂ
- Plans Are Worthless, but Planning Is Everything
- Christopher Browne: Everyone Likes to Buy Cheap, Except in the Stock Market
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