Both stocks and bonds are essential to the creation of a diversified portfolio that yields long-term results. Because stocks and bonds often move in opposite directions, bonds provide a natural hedge against stock market corrections. They also provide income. Stocks will appreciate more long term, so those with long time horizons and the ability to tolerate risk do better with a large percentage of stocks compared to bonds, while those with short time horizons should keep more money in bonds. Investors also boost returns by changing their stocks vs bonds allocations according to economic conditions.
What Are Stocks vs Bonds?
The creation of a diversified investment portfolio requires knowledge of the differences between stocks vs bonds and how they react to changing economic and market conditions. Generally speaking, stocks offer far more upside potential than bonds; however, the investor must accept higher risk, including significant loss of principal. Bonds, on the other hand, protect the investor’s principal while guaranteeing steady income in the form of semi-annual interest payments.
Different Strokes for Different Folks
Most investment experts believe that all investors, old and young, should have exposure to both of these asset classes, as well as placing a small percentage of net worth in alternative assets such as precious metals. As a rule of thumb, younger investors should have far more stocks than bonds while older investors should reduce exposure to stocks and place their stock investment profits in high-quality bonds. For example, an investor in his or her 20s might opt from 90% stocks and 10% percent bonds. An investor nearing retirement may choose a 60% to 40% stocks vs bonds allocation.
Many nonprofessional investors who have 401(k) retirement accounts follow recommended allocations of stocks vs. bonds based on age and risk tolerance. Since stocks deliver better results over the long term but may temporarily decline markedly, they are more suitable for investors with a long time horizon who can ride out price declines without needing to sell stocks and realize losses. Bonds are more suitable for those who will need the money in the near term, such a retirees and those nearing retirement age.
Often, investors pay too little attention to the fundamental differences between stocks vs bonds. To fully comprehend the difference between them, it’s important to look at the fundamental characteristics of each.
What Are Stocks?
Stocks are an ownership stake in a company. When companies need to raise capital for expansion plans, they often issue stock through an initial public offering (IPO). Investors purchase the stock if they believe that the company’s plans will succeed and the IPO price makes sense. Depending on the IPO price, the stock may rise drastically soon after going public. In that case, investors are very bullish on the company and feel the IPO price was a bargain. In contrast, the stock may fall after issuance if the street loses faith in the company or feels the price is just too high.
Setting the Value
The prices of stocks are set by the market. Investors have differing opinions about how much a stock should sell for. As a result, stock reports contain polls of fair value estimations from several professional stock analysts. They often have a broad range and, more often than not, lead investors to conclude that the fair value lies somewhere in the middle. Like analysts, investors have broad viewpoints on fair value. As a result, the market price tends to be the consensus view amongst investors rather than the view of outliers, though future price movements sometimes prove the outliers prescient.
From the investor’s perspective, the most important difference between stocks vs. bonds lies in stocks’ reliance on company performance. Since bonds are a loan to the company, the obligation to pay interest and return the principal remains in force regardless of company performance, except in cases of bankruptcy. Stock values are determined wholly by the market’s opinion of the company’s performance. If it slips, the stock falls. When expectations were high and the slippage comes as a surprise, stock price declines are steep.
Types of Stocks
Most stock is common stock, or alpha. This type of stock is built for growth. Many common stocks pay no dividend. These are considered growth stocks because profits must come from appreciation. Growth stocks carry the most risk. Larger, more stable companies pay dividends to common stockholders and are both less risky and less likely to achieve alpha.
Preferred stock is more about yields than growth. Companies issue preferred stock to investors who want higher dividend yields and less market risk. Unlike common stocks, preferred stocks pay a guaranteed dollar amount per share, similar to bond yields. Common stocks pay a percentage yield that varies with the market. Preferred stockholders also have claim to dividends ahead of common stockholders. Preferred stocks also offer the advantage of being more frequently bought back by the company at a significant premium.
Regardless of whether investors choose to hold any preferred stock, they must diversify between multiple types of stocks in order to avoid losing tremendous value because of problems in a certain sector, region or class of stock. Important diversification considerations include the following:
- Company size
- Growth stocks
- Income stocks
- Value stocks
What Are Bonds?
As with stocks, companies issue bonds to fund expansion. Bonds may also help the company sustain day-to-day operations or service other debt. Governments also issue bonds to raise money.
Government bonds fund public sector budgets and pay off previous debts. U.S. Treasury securities are some of the safest investments in the world. Since the U.S. Government can always create money and new bonds, U.S. Treasury obligations will always be paid. The exception to this would be an extreme economic and currency collapse, something that has never happened in U.S. history.
Corporate bonds are also considered safe investments. Ratings agencies like Moody’s issue bond ratings. The highest rating indicates that the company has a very strong balance sheet and that the chances of default are virtually zero. Bonds with lower ratings have a higher chance of default, but as long as the rating is considered investment grade, the chances of default remain very small. Speculative grade bonds, also known as junk bonds and high-yield bonds, come with a real risk of default.
The interest rate on the bond depends on its rating. Investors looking for a safe investment that has virtually no risk of losing principal should stay with investment grade bonds. Speculators and aggressive investors can consider high-yield bonds, though diversification is essential. Since some junk bonds are likely to default, investors need to accept the risk of total loss on some of these bonds. With proper diversification, the high yields on other bonds will offset any defaults.
How Bonds Work
For the uninitiated, bonds can seem a bit confusing and counterintuitive. Though bonds may seem complicated at first, there is actually an elegant logic to how they are structured that makes bond price movements highly predictable.
When a bond is issued, par value is established. Par value is the amount of money the company or government borrows from the bondholders. Par value will be paid to the bondholder at the predetermined maturity date. Short-term bonds have maturity dates between six months and several years, while long-term bonds have maturity dates up to 30 years after issuance. It’s important to note that the bondholder paid on maturity date is oftentimes not the original buyer. Since bonds trade on the open market, the original owner usually sells the bond beforehand and a bond may change hands many times.
Buying a Bond
At issuance, a bond may be sold at par value, above par value or below it. The market price depends on the bond’s coupon rate and current market interest rates. The coupon rate is the rate of interest paid to the bondholder each year. If the coupon rate matches market interest rates, the bond will sell at par value. However, should interest rates fall, the market will consider the bond more valuable because it pays a higher interest rate vs the market. Should interest rates rise, the market considers the bond less attractive and the price must be discounted to attract buyers.
For example, imagine a bond with a $1,000 par value and a 4% coupon rate. This coupon rate means that the bondholder receives $40 per year in interest, or 4% of $1,000. Once the bond is issued, the $40 payment remains fixed for the life of the bond. In other words, regardless of what happens to market interest rates, the $40 payment is always the same. Because of this, when interest rates rise, the value of the bond must decrease in tandem. The decrease in price allows the fixed $40 payment to match the higher interest rates.
Bond investors watch the Fed very closely to gain an understanding of its plans to decrease or increase interest rates. Any move by the Fed directly impacts the value of bond portfolios. Upon the announcement of an interest rate increase, bond investors are quick to react. They know that the value of their current bond holdings that are below the new interest rate level will decline in value for their yields to remain competitive. An interest rate cut makes bond investors very happy. In addition to the interest payments, their bonds will increase in value.
This leads to a tendency for bonds to increase in value based on bad economic news. Investors try to forecast the chances of an interest rate cut in the near future. Because the Fed cuts interest rates when the economy falters, bond investors interpret bad economic news as a bullish sign for their portfolios. This runs counter to stocks, which often see broad market declines when economic indicators show a deterioration in market conditions.
Owning bonds in addition to stocks provides a hedge against stock market declines. When stocks falter, it’s usually due to a softening economy. The Fed’s mandate is to keep the economy growing and at full employment. Investors know that when stocks decline, interest rate cuts often follow. As a result, bonds often rise in value when stocks fall, providing the investor with a cushion against a stock market correction.
Final Thoughts on Stocks vs Bonds
Stocks vs bonds is about understanding how these important asset classes work together in a diversified portfolio. Bonds surge as the economy falters and interest rates inevitably drop. This makes them a perfect hedge against stock market declines. Stocks provide far superior returns over the long haul but are prone to heart wrenching short-term declines. Investors with short time horizons are wise to weight their portfolios with more bonds, which provide safety and income. When it comes to stocks vs bonds, the key difference is bonds offer income and safety and stocks offer growth and volatility.