How Are Stocks Like Bonds?
By Bryan Caplan
From John Cochrane:
The standard portfolio rule says that your stock percentage should
rise with the expected return (stocks and bonds) divided by squared
return volatility. So, if you were happy with a 50/50 portfolio with an
expected return of 7% and 15% volatility (standard numbers), 50%
volatility means you should hold only 4.5% of your portfolio in stocks!
investors and hedge funds who use this standard formula are getting
out, waiting for at least a return of lower volatility before getting
The answer to this paradox is that the standard formula is wrong. It
assumes that stocks are a random walk, and the chart tells us
otherwise. Stocks act a lot like long-term bonds — when prices decline
and dividend yields rise, subsequent returns rise as well.
Good bond investors know this. If you have a 10-year Treasury
indexed bond, and a 10-year liability (say, you want to retire in 10
years), and you desire complete safety, you can ignore quarterly
statements. If you see interest rates rise, bond prices tank, and bond
volatility go through the roof, you would be foolish to call your
broker and cry, “We’ve got to sell! I can’t take any more losses.” …Stocks are
much riskier, of course. But the same logic explains why you can ignore
“short-run” volatility in stock markets.