Stocks Versus Bonds
As an investor, you are likely to weigh the advantages of owning stocks versus bonds while putting together a financial plan. Comparing stocks against bonds begins with knowledge of basic corporate finance. From there, you can compare potential risks versus rewards between these two important asset classes. When building your portfolio, the proper investment strategy varies according to your life goals and time frame.
A corporation issues both stocks and bonds to investors to secure financing. Bonds are actually credit securities, where investors earn interest payments until their loans mature. Alternatively, shares of stock represent ownership claims over the underlying business. In some cases, shareholders will collect dividends that are paid out of business profits.
Risk Versus Reward
Bond asset claims are senior to those upon shares of stock. This means that bondholders are to be paid off first–from asset liquidation sales that occur amid corporate bankruptcy. Corporations are also legally mandated to make bond interest payments. Cash dividends on stocks, however, are paid out at management’s discretion.
Because of this asset claim relationship, stocks are more volatile investments than bonds. Stock prices generally track corporate profits, which can swing wildly between zero and infinity over the long term. Bond prices fluctuate at a much more gradual pace, alongside the interest rate environment. Higher interest rates cause the prices on current bonds to decline. At that point, new bonds make higher interest payments–so old bonds will sell for a discount.
As a benchmark for U.S. stock market performance, the S&P 500 has averaged 11 percent annual returns since its 1957 inception. This 11 percent average does include several peaks and valleys that coincide with the economic cycle of growth, recession, and recovery. In 1995, the S&P 500 posted a 38 percent return amid the 90’s technology boom. In 2008, the S&P 500 lost 37 percent of its value during a recession and housing crisis.
For bonds, the Barclays Capital U.S. Aggregate Bond Index has averaged a 7 percent annual return since 1989. This figure includes a 3 percent loss and 19 percent gain in 1994 and 1995, respectively.
Stocks are especially volatile amid recession–when corporate profits significantly contract. Alternatively, bonds are more so affected by inflation risks, which reduce purchasing power on cash. In response to inflation, the Federal Reserve often supports higher interest rates to slow down the economy. Again, higher interest rates translate into falling prices for existing bonds.
Stocks and bonds are both subject to systematic risk, where the entire financial system seems to be on the verge of collapse. Stock market crashes and credit crises are the epitome of systematic risk.
A diversified portfolio may include stocks, bonds, and money market securities. Stocks are ideal for long-term growth. Meanwhile, bonds and money market assets provide a ready source of interest income and cash to stabilize your portfolio in most conditions. As you age and near retirement, you should increase your exposure to bonds and money market securities.