Stocks Versus Bonds: Which Investment is Right for You?
Taken together, stocks and bonds are the gasoline and engine oil that power financial markets and ignite the global economy. All investors must operate with a passing knowledge of corporate finance – to better appreciate risk profiles for these separate asset classes.
Onyx Investments will recommend the right mix of stocks and bonds for your portfolio according to your investment risk tolerance, time frame, and life goals.
Corporate Finance 101
Corporations issue both stocks and bonds to investors to finance business operations. Bonds are credit securities; and investors collect interest payments through the term of the loan until bond principal is repaid at maturity.
Shares of stock represent equity ownership claims above the corporation. Shareholders profit from both dividends and capital gains. Dividends are paid out of business profits before capital gains are realized when selling stock at a profit.
The corporate balance sheet equation shows that assets equal liabilities plus shareholder equity. Debt and equity, again, are sold to raise cash and assets.
Financial Risks Versus Rewards
Bond asset claims are senior to those of shares of common stock. As creditors, bondholders are to be paid off first, in the event of bankruptcy and asset liquidation.
Corporations are contractually obligated to make good upon bond principal and interest payments. Alternatively, cash dividends are declared and paid out at the discretion of management. A corporation is highly likely to eliminate the dividend altogether amid a severe economic downturn to preserve cash.
For this, stocks are far more volatile investments relative to bonds. Share prices track corporate profits over the long term, which may range anywhere from between zero and infinity.
Bond prices fluctuate alongside gradual shifts in prevailing interest rates. Higher rates adversely affect the bond market. New bonds would then offer higher interest payments; and old bonds must sell for steep discounts in order to attract investors.
Inflation and higher interest rates are a devastating one-two punch for all conservative, fixed income savers. The Federal Reserve Board has aggressively driven the federal funds rate from zero to 5.25% in two short years – in an attempt to stifle white-hot COVID-19 era inflation.
Market Benchmarks and Historical Returns
The Standard and Poor’s 500 Index, as a U.S. stock market benchmark, averages eleven percent annual returns since its 1957 inception. The eleven percent average, of course, includes multiple boom and busts through the economic cycle.
For 2023, the S&P 500 returned 24%. This strong showing followed up a dismal 2022, a year in which the market declined by nearly 20%. Prior to the pandemic era, the stock market suffered through brutal 38% 2008 Great Recession losses.
For bonds, we expect long term annual returns to come in a few percentage points above the rate of inflation. Last year, in 2023, Baa-rated corporate bonds paid out a steady 8.74% total return. For 2022, these same bondholders suffered through 15% losses, amid a sharp spike in interest rates.
Interestingly, the bond market is slightly larger than the stock market, with both classes coalescing near $125 trillion in respective value. Still, the bond market receives far less attention than the casino-like atmosphere of stock trading.
We do expect for stocks to be especially volatile amid recession when corporate profits significantly contract. Still, we accept this volatility, as the cost of doing business for real growth.
Long term stock market returns are far superior to any other asset class. For this, bondholders are especially susceptible to opportunity cost risks, or the loss in potential profits from competing investments. Conservative savers, by definition, do prioritize safety of principal over real growth.
A diversified investment portfolio might include real estate alongside money market, credit, and equity securities. Here, cash management products and regular investment income are reserved to meet day-to-day expenses and intermediate savings targets. Stocks, of course, are best reserved for long-term holdings.
Onyx Investments will recommend increased exposure to bonds and money market securities as clients age and near retirement.