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Stocks vs. bonds

Chris Farrell Apr 27, 2012

Tess Vigeland: Anyone with an investment portfolio knows this rule of thumb: If you want spice in your life, buy stocks. If you want to play it safe, bonds are the way to go. But recently some big name investors have been turning that rule on its head.

Our economics editor Chris Farrell looked into it.

Chris Farrell: It’s one of the most basic rules of thumb in the investing world: Bonds are safer than stocks.

Jim Paulsen is chief investment strategist at Wells Capital Management. He explains it this way:

Jim Paulsen: Typically through time, bonds tend to have less total return volatility.

What he means is, bonds are more stable. They don’t make the massive gains that stocks can make, but they rarely fall as sharply as stocks, either.
So when Warren Buffet says, and I quote, “Bonds should come with a warning label,” I get confused. Jim?

Paulsen: Stocks are so under-owned relative to how much they could be and bonds are so over-owned.

Paulsen says people have been spooked by the bad economy and the ups and downs in the stock market. They’ve pulled their money out and put it in a safe place — bonds, U.S. Treasuries in particular. That’s kept stock prices low, and pushed bond prices up. Paulsen says that’s a dangerous state of affairs.

Paulsen: When you start to grow again people worry less about recession and they’ll instantly start worrying more about the potential for inflation. And that could come out in rapid upward movements in bond yields, which would mean big downside price risk in your bond holdings.

Translation: As the economy recovers, investors will start worrying about inflation. To fight inflation, they’ll look for better returns. They’ll demand new bonds, with higher interest rates. And they’ll sell their old bonds. Big time.

That’s why Buffett and Paulsen say bonds are risky right now. The risk is that you could find yourself in the middle of a boom economy, with the stock market going through the roof, holding a bunch of bonds worth a fraction of what you paid for them just a few years before.

Now, neither Buffett nor Paulsen are forecasting what stocks and bonds will do over the next week, month or year. They’re simply echoing a time-honored insight in finance: When everyone owns an investment, danger lurks.

Vigeland: Chris Farrell is the economics editor for Marketplace.

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