If you’re not happy with how much interest you earn from your checking or savings account, you’re not alone. Most of these accounts have interest rates below 1% APY, a number that doesn’t keep up with inflation.
Luckily, investors don’t have to rely on bank accounts to generate high returns. Stocks and bonds have helped investors get more out of their money for centuries. Bonds have been issued for thousands of years, with some early debt instruments dating back to ancient Mesopotamia circa 2400 B.C.E. The first publicly traded company was the Dutch East India Co., which first sold shares to investors in 1602.
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Bonds and stocks can both increase your capital, but these financial instruments operate differently. Amy Braun-Bostich, CEO and founder of Braun-Bostich & Associates, highlights the key differences.
“When you buy a stock, you become an owner of the company. When you buy a bond, you are loaning the company or government entity money for an agreed upon time and rate of interest.”
Bond investors know how much they will earn from a bond. They can look at the interest rate and maturity date to see how much they will make. Stocks give you partial ownership of a company, meaning that the company’s performance plays a role in the asset’s performance.
Here’s what you need to know to understand the differences between stocks and bonds:
— How much can you make with stocks and bonds?
— What are the risks for bonds vs. stocks?
— Diversifying your portfolio with bonds and stocks.
How Much Can You Make With Stocks and Bonds?
Stocks and bonds can both generate long-term returns, but stocks have higher ceilings. Scott McBrien, founder and chief investment officer at Stock Timing Tech, mentions that stocks have historically outperformed bonds.
“Historical data shows that the average return for U.S. stocks, represented by the S&P 500 index, has been around 7% to 10% over the long term.”
Those long-term returns comfortably beat the S&P 500 Bond Index. That index, by contrast, has only generated an annualized return of 2.7% over the past 10 years.
The difference between partial ownership of a company and fixed income from a loan highlights why this gap exists. While loans provide the same interest regardless of a company’s growth, stockholders can achieve higher returns if the company reports year-over-year revenue and income growth, or if the stock value rises on changing investor sentiment.
A well-timed stock investment can accumulate generational wealth in the long run, but that scenario is more difficult with bonds. Bonds have much lower ceilings than stocks because their returns are fixed. It’s possible to find stocks that have doubled within the past five years, but you won’t find bonds that have achieved the same feat for their investors.
What Are the Risks for Bonds vs. Stocks?
While stocks have performed better than bonds in the long run, stocks are also more volatile and can experience more dramatic losses than bonds. These price swings can rattle investors and cause them to exit positions early. Bonds are typically more stable than stocks during economic uncertainty.
“Stocks are generally more volatile than bonds, with prices fluctuating significantly in response to market conditions, economic factors, news and investor sentiment,” says McBrien.
Volatility isn’t a bad thing, as it can result in significant gains. However, sharp price fluctuations can move against you. The risk profile for these assets also varies based on the type of stock or bond. It’s possible to find stocks with very little downside and risk.
“Some stocks are very low risk: They have a proven track record, they most likely pay a dividend, and they move up or down less than the overall market,” Braun-Bostich says. A low price and valuation aren’t enough to justify a buy. Braun-Bostich cautions that some stocks have low prices and valuations for a reason. The same rule also applies to bonds.
While bonds have less risk than stocks, investors should also consider the opportunity cost. The money you put into a bond cannot go into a stock that can produce higher returns. Taking a guaranteed 3% return prevents you from using the same capital to buy a stock that goes up by 10%.
Bonds typically have less downside than stocks, but it is still possible for bonds to lose considerable value, especially with rising interest rates. Interest rate hikes make existing bonds less valuable because investors can get higher yields with newly released bonds.
Bonds with longer terms are more sensitive to interest rate fluctuations, says Braun-Bostich.
“During the recent rate hikes by the Federal Reserve, holders of long-term Treasurys (U.S. government debt) saw 20%+ losses in their bonds.”
[READ: How to Build a Stock Portfolio]
The sudden decline in long-term Treasurys contributed to Silicon Valley Bank’s collapse. Investors can hold onto these bonds until maturity to receive their principal and interest payments, but higher interest rates create better opportunities for future investments.
Rising interest rates also hurt stocks, since those higher rates make it more expensive to borrow money. Corporations may issue bonds or take out loans when they need extra capital. Higher interest rates discourage this type of borrowing and also hurt consumers.
Interest rate hikes lead to higher monthly mortgage payments and additional credit card debt, two factors that can decrease consumer spending and firms’ earnings. Higher interest rates contract the economy and lead to monetary tightening.
Stockholders and bondholders can both get hurt by rising interest rates and other economic factors, but bondholders have an edge during corporate bankruptcies. Stocks become worthless when a company goes bankrupt, but bondholders aren’t left in the dust.
“When the bankrupted company is liquidated, the bondholder may get some of their principal back,” says Braun-Bostich.
Stock investors cannot hope to recoup their investment under this scenario. They may be entitled to liquidated company assets, but this scenario is rare.
Diversifying Your Portfolio With Bonds and Stocks
You don’t have to choose one investment over the other. In fact, it is a good idea to have some of both. A common diversification strategy is to mix stocks and bonds in your portfolio.
“Diversification is a crucial element of a sound investment strategy. Including both stocks and bonds in a portfolio spreads risk. Bonds tend to be less affected by market downturns, acting as a safe haven and counterbalancing stock volatility. Diversification mitigates overall portfolio risk by avoiding reliance on a single asset class,” says McBrien.
Spreading your capital across multiple investments makes you less dependent on one asset’s performance. You don’t want to put all of your eggs in one basket and realize that the basket has a hole at the bottom.
You can buy individual stocks or bonds or simplify your research by investing in mutual funds or exchange-traded funds that contain a portfolio of stocks and bonds. You can also pick a group of funds that contain stocks and a subset of funds that consist of bonds.
Braun-Bostich holds the same view as McBrien on this approach and recommends investors assess their risk tolerances before allocating their capital. “Typically, the ratio of stocks to bonds is dependent on the risk tolerance of the investor. In general, a conservative investor may only have 20% in stock whereas an aggressive investor may have 80% or more in stock.”
Your risk tolerance can also help determine the types of stocks and bonds you buy. Investors with higher risk tolerances may opt for growth stocks and high-yield, or “junk,” bonds with longer maturities. An investor who wants less risk may opt for value stocks and high-rated bonds with shorter maturity dates.
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Bonds vs. Stocks: Differences in Risk and Reward originally appeared on usnews.com
