Traditional asset allocation strategies describe bonds as a lower-risk investment

For decades, advisers have pushed a common narrative: bonds are safe and stable, while equities are the risky component of a portfolio. However, this view oversimplifies the realities of financial risk. A closer look at inflation, default, and long-term performance reveals that equities might not be as risky as they’re often portrayed, and bonds are not as safe as their reputation suggests. In addition, the current spiking in gilt yields is an indicator that even stable government bonds issued by the likes of the UK carry the risk of default, which can become more apparent in the event of a financial crisis.

Bonds carry significant inflation risk. Their fixed returns mean that rising prices erode their purchasing power. If inflation exceeds a bond’s yield, the investor experiences a net loss in real terms.

The threat of default is another critical issue. While government bonds from stable countries are considered “risk-free,” corporate bonds and those from less stable nations carry the possibility of default. Even high-rated bonds can lose value if downgraded, creating losses for investors. High profile defaults include Greece in 2012, Argentina in 2020 and Sri Lanka in 2022.

Interest rate risk also plagues bonds. As rates rise, the value of existing bonds falls. In low-yield environments, even small rate hikes can lead to significant capital losses, particularly for those who sell before maturity.

Equities, on the other hand, offer natural inflation protection. Companies can adjust prices to reflect inflation, maintaining or growing their earnings in real terms. This resilience makes equities a better long-term store of value.

Traditional risk allocation strategies, such as the 60/40 portfolio split, assume that bonds are the stabilising force and equities are the source of volatility. However, this perspective ignores the long-term risks of bonds and the growth potential of equities. Bonds may appear stable in the short term, but inflation and reinvestment risks make them less reliable over time.

Investors should rethink how they allocate assets, focusing on inflation protection, growth potential, and default resilience. A more flexible approach could prioritise equities alongside alternatives like property or commodities for better diversification and inflation hedging.

Equities are often misunderstood as high-risk, but they may actually provide a more balanced risk-reward profile, especially over the long term. By challenging outdated allocation strategies, investors can build portfolios that better reflect the complexities of modern markets.

The current fears around the yields in the gilt market are a good example of the misunderstanding regarding the risk of fixed-income assets.