3 Graphs: How Risky are Stocks, Bonds and Cash?
Hat tip to the Wealth of Common Sense blog for updating their performance charts which help demonstrate a key concept in investing: risk. Risk is one of those nebulous concepts for teens who have never experienced a severe market correction while holding stocks. These charts help elucidate risk from a mathematical perspective by plotting returns for the three basic asset classes: cash, bonds and stocks. By using the same scale for each, it becomes more apparent which is the riskiest asset.
A few more notes on the charts:
- The red line in each chart is the average.
- Real returns are calculated as actual return minus the inflation rate.
- Cash = 1 month T-bills
- Bonds = 5 year Treasury bonds
Questions for your students:
- I didn't think you could lose money by holding cash and yet many of the recent years in the Real Cash Returns graph are negative. Why?
- What is the average real return over the 90 year period for each of these assets?
- Comparing the three graphs, which chart has the widest dispersion of points? least dispersion? What does that tell you about investing in that asset (cash, bonds or stocks)? Which do you think is most risky? Least risky?
- Is there a relationship between risk and return as seen in these charts? In other words, is the riskiest asset the one with the highest average return too?
- What is the range of returns (highest to lowest) for each of the three graphs?
- The stock market (S&P 500) returns about 6-7% annually on a real basis. Follow the red line (the average) across the S&P 500 graph. About how many of the 90 years captured in this graph fall on the average line?
- Look at the years FOLLOWING the year of the WORST returns for Cash, Bonds and Stocks. Is it typically a good time to invest in these assets after they have had a very bad year? Do the same analysis following the year of their BEST returns. Is that a good time to invest?
- Many experts believe that it is a good idea to diversify and own both stocks and bonds since they tend to move in opposite directions. Compare stock market returns with bond returns in 1974, 2001 and 2008 to see whether diversification would have helped you during a bear market (>20% loss) for stocks.
About the Author
Tim's saving habits started at seven when a neighbor with a broken hip gave him a dog walking job. Her recovery, which took almost a year, resulted in Tim getting to know the bank tellers quite well (and accumulating a savings account balance of over $300!). His recent entrepreneurial adventures have included driving a shredding truck, analyzing executive compensation packages for Fortune 500 companies and helping families make better college financing decisions. After volunteering in 2010 to create and teach a personal finance program at Eastside College Prep in East Palo Alto, Tim saw firsthand the impact of an engaging and activity-based curriculum, which inspired him to start a new non-profit, Next Gen Personal Finance.
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