Stocks and bonds each possess their own sets of advantages and disadvantages. Furthermore, each asset class features dramatically different structures, payouts, returns, and risks. Understanding the distinguishing factors that separate these two asset classes is key to building a healthy investment portfolio that thrives over the long haul.
Of course, asset allocation mixes are unique to each individual, based on an investor's age, risk tolerance, and long-term investment and retirement goals.
Key Takeaways
- Stocks offer the potential for higher returns than bonds but also come with higher risks.
- Bonds generally offer fairly reliable returns and are better suited for risk-averse investors.
- For most investors, diversifying portfolios with a combination of stocks and bonds is the best path toward achieving risk-mitigated investment returns.
Buying Stocks Instead of Bonds: An Overview
Stocks are essentially ownership stakes in publicly-traded corporations that give investors an opportunity to participate in a company's growth. But these investments also carry the potential of declining in value, where they may even drop to zero. In either scenario, the profitability of the investment depends almost entirely on fluctuations in stock prices, which are fundamentally tied to the growth and profitability of the company.
A bond is a fixed income instrument that represents a loan made by investors (known as "creditors" or "debtholders") to borrowers, which are typically corporations or governmental entities. Also known as coupons, bonds are characterized by the fact that the ultimate payouts are guaranteed by the borrower. With these investments, there is a concrete maturity date, upon which the principal is repaid to investors, along with interest payments attached to the interest rate that existed at the onset of the loan.
Bonds are used by corporations, states, municipalities, and sovereign governments to finance a multitude of projects and operations. That said, some bonds do carry the risk of default, where it is indeed possible for an investor to lose their money. Such bonds are rated below investment grade, and are referred to as high-yield bonds, non-investment-grade bonds, speculative-grade bonds, or junk bonds. Nevertheless, they attract a subset of fixed income investors that enjoy the prospect of higher yields.
Pros of Buying Stocks Instead of Bonds
The chief advantage stocks have over bonds, is their ability to generate higher returns. Consequently, investors who are willing to take on greater risks in exchange for the potential to benefit from rising stock prices would be better off choosing stocks.
Investors may also wish to consider investing in dividend-paying stocks. A dividend is essentially a distribution of some of the profits that a corporation makes to its shareholders. And any dividends that are not taken may be re-invested in the businessin the form of more shares in a company.
Bonds also pay regular income in the form of interest payments; however, these cannot be reinvested back into the same bond. Interest rates can change over the life of the bond, which creates reinvestment risk, or the risk that new bonds will have lower yields than the ones you are receiving interest from.
Diversifying investments across both stocks and bonds, marries the relative safety of the bonds, with the higher return potential of stocks.
Cons of Buying Stocks Instead of Bonds
In general, stocks are riskier than bonds, simply due to the fact that they offer no guaranteed returns to the investor, unlike bonds, which offer fairly reliable returns through coupon payments. Stocks are inherently more volatile than bonds because in the event of a corporate bankruptcy, bondholders (who are a company's creditors) have priority in being repaid. Meanwhile, owners of common stock are last in line, and can end up with nothing if the company goes bankrupt.
Risk-averse investors looking to safely deploy their capital and take comfort in more structured payout schedules would be better off investing in bonds.
Have Stocks or Bonds Performed Better Historically?
The historical returns for stocks have been between 8%-10% since 1928. The historical returns for bonds have been lower, between 4%-6% since 1928. Over the past 30 years, stocks have returned an average of 11% annually; while bonds have returned just 5.6% per year, on average.
How Much of My Portfolio Should Be in Stocks?
A well-diversified portfolio contains a broad range of holdings across several asset classes. In general, the longer your time horizon (i.e., the younger you are), the more risk you can take on. Therefore a portfolio weighted 80-90% in stocks and the rest in bonds or other assets is bearable. However, as your time horizon shortens, it is recommended to shift your allocation increasingly toward lower-risk bonds and reduce your allocation to stocks.
Why Do Stocks Generally Outperform Bonds Over Time?
Stocks generally outperform bonds over time due to the equity risk premium that investors enjoy over bonds. This is an amount that investors of stocks demand in return for taking on the additional risk associated with stocks. Stocks also benefit from a growing economy. As GDP grows, so too do corporate profits, which are reflected in the prices of stocks, but not typically in bonds (which are essentially loans).
