In the wake of 1995's rip-roaring stock market gains and the neat follow-up in 1996, many investors are worrying about whether to take some money off the table. From their newspaper in the morning to the television at night, they are bombarded with talk about the market's riskiness. The solution to such angst, they are told, is simple: Lower the risk level in your portfolio, and sleep better at night by moving some money out of stocks and into the sedate world of fixed-income investments.
Investors who are seduced by such advice may be in for a rude shock. Sure, big swings in the stock market within the trading day make it seem riskier lately. But dig deeper, and a different picture emerges. According to Chicago-based Ibbotson Associates Inc., the Standard & Poor's 500-stock index actually was less volatile in the past five years than in the previous five. At the same time, the market's returns were greater (chart). So investors got fatter returns with less risk, not more.
Many investment strategists say the bond market is the big swinger these days--and hardly a safe haven. Its reputation for stability is a hangover from a very different bond market of decades ago. While its volatility has come down in recent years, it is riskier than many investors may realize.
To gauge the risk of an investment, statisticians rely on a measure called the standard deviation. After calculating the average return of an investment over a given period, statisticians measure how much returns have deviated from the average. The greater the fluctuation, or standard deviation, the greater the chance of wide swings in returns, both above and below the average--and the greater the risk.
An analysis of the standard deviation of the S&P 500 deflates the idea that today's stock market is extremely volatile. In fact, the period from 1991 to 1995 was the least volatile five-year period for the index since its inception in the 1920s. From 1991 to 1995, the S&P 500 deviated just 11.7% from its average, or mean, return. That compares with a far-greater 21.5% from 1986 to 1990.
A DIFFERENT DOW. Ibbotson looked at monthly numbers, but daily numbers also show a less volatile stock market. Jeremy J. Siegel, a finance professor at the Wharton School of the University of Pennsylvania and author of Stocks for the Long Run, notes that the average day-to-day price change in the Dow, at less than 0.65% today, is slightly below the long-term average of 0.69%.
Still, the popular perception is that the stock market is highly volatile. One oft-quoted statistic seeming to support that notion is that the New York Stock Exchange's 50-point "collar," which limits certain kinds of trading when the Dow moves 50 points, has been triggered a record 58 times in 1996. But couching market volatility in points, rather than in percentages, makes market fluctuations appear far worse than they are, says Abby Joseph Cohen, co-chair of the Investment Policy Committee at Goldman, Sachs & Co. In 1990, when the NYSE's collar was introduced, a 50-point move represented about 2.5% of the Dow. Today, a 50-point move is less than 1% of the Dow.
Investors have themselves to thank for the stock market's reduced risk. The huge inflows into equity mutual funds have dampened the market's moves. Not only have investors shifted money out of bonds and savings deposits and into stocks; they have also directed more of the money in the growing universe of tax-deferred retirement savings plans, such as 401(k)s, into stocks. Since that money is deducted regularly from payroll checks, it gives the market a steady stream of funds. Investors have also helped the market by treating market dips as buying opportunities, which has kept the stock market's drops small.
It's a different story in the bond market. Standard-deviation statistics again tell the tale. Despite low inflation, the volatility of an investment in the long-term Treasury bond was 8.9% from 1991 to 1995. That's below the 12.6% standard deviation in the previous five years. But look further back, and that 8.9% looks awfully high. In the mid-1960s, with inflation at about the same rate as today, the standard deviation was only 2.5%. In fact, in the 14 five-year periods from 1926 to 1995, only four periods displayed higher volatility than the 1991-95 period, mainly because of high inflation.
Investors have been whipsawed by the bond market's wild swings. In 1994, the market had its worst year ever. In 1995, it had one of its best years. And in 1996, the rise in long-bond yields from 5.95% to 7.04% means that the 30-year bond is on track to have another big year on the downside, measured by total return, says James A. Bianco, director of research for Arbor Trading Group Inc. in Barrington, Ill.
The fickleness of bond investors has added to that market's volatility. Until a few years ago, the flows into mutual funds were almost evenly split between stock and bond funds. But after 1994, when the 30-year Treasury lost 11%, bond funds had outflows of $43.4 billion. Some bond funds holding 30-year Treasuries lost more than 17% of their value.
Painful memories of 1994 kept many domestic investors out of the bond market in 1995. That year, buoyed by funds from foreign investors, the bond market had its third-best year ever, with the 30-year Treasury up 34.1% as the Federal Reserve eased rates. But since the stock market did even better, with a 37.5% return, investors continued to pull money from bond funds, albeit just $4.1 billion. So far in 1996, bond funds have seen inflows of $9 billion. That compares with flows of more than $121 billion into stock funds.
There are more fundamental reasons for the increased risks of the bond market. The deregulation of the banking and the financial industries in the 1970s and 1980s injected a lot more volatility into interest rates and bond prices. "Before then, interest rates had been pretty much fixed by the government," says Robert Cummisford, a senior consultant with Ibbotson. Now, with so many more players in the market, both in the U.S. and abroad, bond prices can gyrate with lightning speed.
The nature of fixed-income investing has also changed. Gone are the days when investors simply held bonds until they matured. Fixed-income securities are more actively managed today, so prices bounce around more, says Morris W. Offit, chairman of Offitbank, which specializes in fixed-income management. "You can take a fixed-income instrument today and by leveraging it through derivatives, create an instrument that has a risk profile well beyond the most unseasoned common stock," says Offit.
WILD RIDE. The yield on the long bond has been all over the map in the past few years. It moved from a 22-month low of 5.77% in October, 1993, to 8.16% a little more than a year later. It then fell below 6% last December and now sports a yield of about 7.04%. Inflation, meanwhile, has stayed in a narrow band of 2.5% to 3%.
Jeremy Siegel places much of the blame for the long bond's volatility on Fed policy. He argues that the Fed isn't adjusting short-term rates frequently enough. He takes issue with the Fed's practice of announcing moves in short-term interest rates in conjunction with Federal Open Market Committee meetings, which take place eight times a year. "When the Fed doesn't allow the short-term interest rate to fluctuate in response to market forces, the entire burden of adjustment falls on the long-term rate, leading to wide swings in the market," says Siegel.
The presence of more speculative players in the bond market is also ramping up risk. At a time when the bond market is not getting much investor money to act as a shock absorber, the rapid-fire buying and selling of hedge funds is magnified. A recent hedge-fund strategy that unsettled the bond market involved borrowing in yen to buy Treasuries. "Since the summer of 1995, when the hedge fund's yen/Treasury bond arbitrage trades started coming in, the bond market has become the domain of the big arbitrageur," says Mitchell J. Held, chief economist for Smith Barney Inc.
Lower volatility in the stock market doesn't mean that investors won't have a bumpy ride. But those opting for the "safety" of bonds should be aware that they may be setting themselves up for some sleepless nights.