Question

People who might need to retrieve part or all of their investment relatively soon, such as the elderly, are often advised to invest a higher percentage of their money in bonds, and thus a lower percentage in stocks, than people who can leave the investment untouched for decades. We know, however, that bonds typically have a lower rate of return than stocks.

Why would people be advised to invest in assets that give lower average rates of return?
a. This is bad advice. People should always invest in whichever assets have the highest average rate of return.
b. Although stocks have a higher rate of return in the long run, they are much more volatile, or riskier, in the short run. Therefore, there is a higher probability that the value of the stocks will be less than the original value of the investment for people who might need to withdraw the investment in the short run.
c. Since bondholders get paid before stockholders in the event of bankruptcy of a firm, the average "real" rate of return on stocks and bonds will be the same, with bonds being less risky.
d. Although stocks have higher average rates of return in the long run, bonds have higher average rates of return in the short run. Therefore, bonds are likely to be more profitable for people who might need to get their investment back in the short run.

Answer 1

b. Although stocks have a higher rate of return in the long run, they are much more volatile, or riskier, in the short run. Therefore, there is a higher probability that the value of the stocks will be less than the original value of the investment for people who might need to withdraw the investment in the short run.

Step-by-step explanation:

The relationship between risk and return plays an important role here. Although stocks have higher returns on average, they are much riskier. One way in which this higher risk can manifest itself is through a portfolio value that fluctuates a lot. So, it is more likely that $1,000 invested in a diversified stock portfolio will be worth only $800 at some point than $1,000 invested in a diversified bond portfolio. If the investor is going to need that $1,000 back at some point soon, then it might be wiser to invest in the lower‑average‑return bond portfolio.

Stocks surely have higher rate of return in the long run but are highly volatile in the short run. If an investor, especially older person, who might need his money in the short run may find that his current value of stock is less than the value of investment. Thus the investor may incur a net loss even if the stock may have high rate of retun in the long run. Hence it is advisable to invest more in bonds if money is to be withdrawn in the short run.