Summary: Understanding your financial needs is key to choosing between stocks and bonds.
- Stocks offer higher growth potential but carry more risk.
- Bonds are more conservative but provide lower returns.
- Investment choice depends on personal goals, risk tolerance, and financial stage.
- A diversified portfolio combining both stocks and bonds is often recommended for balanced risk and reward.
There are many different approaches and strategies available to investors today. A diverse portfolio may consist of bonds, stocks, mutual funds, real estate, and other investment vehicles.
The question of whether you should invest in bonds or stocks is an age-old financial debate. It is often top of mind for those entering different phases of investing.
We want to make one thing clear before going any further. The answer to the question “Is it better to invest in stocks or bonds?” is different for everyone.
Both asset classes have potential advantages and drawbacks. Depending on where you are in your career and how close you are to retirement, one may be more beneficial than the other.
Whether you purchase them directly or use a retirement vehicle like a 401k, investing in stocks or bonds may not be the right way to frame the question. Depending on your circumstances, you may want to invest in both or move the focus of your investing from one to the other over time.
The most important thing you can do is learn about these two types of assets. Understanding what sets them apart, their historical rate of return, and what makes them attractive can help you make a more informed decision about your financial future.
Bonds vs. Stocks
Investing in bonds tends to have a much lower risk than investing in stocks. Stocks, on the other hand, tend to have a much higher opportunity for growth. As a result, beginner investors will wonder if it’s better to invest in bonds or stocks, struggling to decide how to allocate contributions to their portfolio.
What is a Bond?
A bond is a loan made by an investor to a borrower. These typically include corporations and governments. Bonds can also be issued by municipalities — local governments.
Bonds outline the loan details, such as the term, interest rate, and repayment structure at issuance. Because of their clear repayment structure, bonds have proven to be a stable asset.
Companies and governments issue bonds to obtain funding for projects that require more funds than they have on hand. Once issued, the investor becomes a creditor of the bond issuer.
Most bonds pay a fixed rate of interest throughout the year. Some municipal bonds offer floating rates, where the rate is periodically adjusted to track a prevailing market rate, such as the Fed Funds rate.
When purchasing bonds, you will either receive a fixed interest rate or a variable rate. Individuals expecting to utilize bonds when approaching retirement might lean toward bonds that have fixed rates.
Bonds allow for various terms. You can also choose from short-term bonds (less than a year), medium-term bonds (a year to ten years), and long-term bonds (more than ten years).
What is a Stock?
A stock (also known as a share) offers an investor (or shareholder) an equity stake in a company.. When a stock is purchased, the shareholder becomes a fractional owner of the organization, allowing them to share in the company’s growth.
Investors buy stocks with the hope that their shares increase in value over time. The company may also pay money to shareholders through dividends. Though there is a risk of loss, stocks have historically outperformed almost all other investment types. That’s a major part of what makes them so attractive to a wide range of investors.
Publicly traded corporations generally issue stocks as a way to raise funds for operational expenses. Stocks tend to be more volatile than bonds but also offer a higher potential return than bonds.
Stocks are always a variable-rate investment. There are no guaranteed returns, and factors such as the company’s performance and market conditions determine the value of your shares. Stocks do not have specified terms and can be bought and sold at the stockholder’s discretion.
Investing in Bonds or Stocks: Key Differences
The key difference between a stock investment vs. a bond investment is ownership. When you purchase a bond, you do not own a portion of the company. Instead, you own a contract that states the entity that issued the bond owes you a form of repayment. It is a debt to be collected in the future at a specified time with specified interest.
A stock, on the other hand, provides shareholders with equity ownership in the organization. The stockholder chooses when to sell their shares rather than at a predetermined time. The value of the stock will vary based on the company’s performance and other market conditions.
Stocks vs. Bonds: Which is The Best Investment?
As we’ve pointed out, there is no single answer to this question. Many factors play a role in determining what type of investment will best fit you as an individual.
However, you can reduce the investing in stocks vs. bonds debate, at least in the big picture. Consider bonds as the more conservative option and stocks as the higher risk, higher reward option.
In general, bonds are fixed-income vehicles that are low risk and generally a low fixed rate. Stocks, on the other hand, are equity vehicles that have historically outperformed most other investments.
Because stocks tend to (significantly) outperform bonds over time, they are generally considered a better focus for most investors. However, there are plenty of scenarios where an investor may favor bonds over stocks.
Generally speaking, holding bonds within your investment portfolio provides a cushion to hedge against losses incurred by stocks. A diverse portfolio will be ideal for most investors. Speak with a financial advisor about your current and future financial plans to confidently determine how heavily you should be investing in corporate bonds vs. stocks vs. mutual funds and other instruments.
The Right Time to Invest
It is never prudent to attempt to time the market. However, it is crucial to time your own financial goals.
When you consider your current situation and your future plans, you can determine the ideal approach to your investment strategy. Bring a knowledgeable financial planner into the mix as well, and you’re setting yourself up for success.
When to Buy Bonds Over Stocks
Bonds tend to hold a smaller portion of a typical investment portfolio. Thus, they are the conservative component of a healthy asset allocation.
One example of when someone may choose to invest in corporate or government bonds instead of stocks is when approaching retirement with adequate funds to meet their future needs.
An investor who finds themselves in this position may transition to a bond-heavy portfolio to avoid the risk of major losses without the time to recover. When you already have the funds you need for retirement, you may decide to protect them with a safer investment, even if the returns are lower than other options.
Because goals and circumstances will vary from one individual to the next, not everyone facing this scenario will be best served by this approach. Instead, develop an intentional strategy with an experienced advisor to determine what is best for your unique situation.
When to Buy Stocks Over Bonds
When you are investing for the future, focusing on bonds may not be your best choice. Bonds will generally take a backseat to stocks in terms of importance to an investment portfolio.
Many investors choose to invest in stocks over most of their retirement planning years because stocks tend to outperform just about every other investment vehicle over time.
Historically, stocks have performed about 20% better than bonds. Stocks have averaged returns of about 10% over the past 98 years. Bonds have returned 6.8% from 1981 – 2021.
When we look back to the Great Depression as a benchmark, we see stocks outperforming bonds by about 35%, returning an average of around 9.59% compared to 5.59% for bonds.
Investing in Stocks vs. Bonds: Risks vs. Rewards
The stocks vs. bonds debate will rage on as long as there is a financial industry. Both bonds and stocks carry different levels of risk.
When deciding to invest in bonds or stocks, it’s important to consider the degree of risk you’re comfortable with, your time horizon for growth, and your future needs. To best evaluate these two options, let’s tally up the primary pros and cons of each.
Pros and Cons of Bonds
As with all investment products, bonds have benefits and drawbacks. Let’s take a look at some of the pros and cons of bonds.
Pros
- Bonds are considered safer investments than stocks. If you invest in corporate bonds vs. stocks, most will not be at risk of becoming entirely worthless.
- Bonds are easily purchased and can be traded before maturity on secondary markets.
- Bonds are transferable.
- Most bonds have many term options.
Cons
- Bonds generally have lower returns than stocks.
- When purchasing bonds, you sacrifice opportunity for stability.
- Bonds are not without risk; when the issuing entity faces difficulties, it may struggle to fulfill its repayment promises. Remember that bonds present less risks than stocks overall, but are not entirely guaranteed or completely risk-free.
Pros and Cons of Stocks
Now that we’ve gained a broad understanding of bonds, let’s look at the pros and cons of these stocks as an investment option.
Pros
- Stocks have some of the highest historical returns.
- Stocks are traded easily within brokerage accounts and other trading platforms.
- Large amounts of information are readily available to investors considering individual stocks or funds.
Cons
- The highest reward also brings the highest risk. A market downturn can reduce wealth accumulated in stocks if these assets haven’t been sold.
- Market fluctuation can be emotionally challenging or lead to rash or emotional decision-making.
- Attempts at market manipulation related to stocks are also a risk.
Learning from the Past
If history repeats itself, we surely ought to consider moments from the past when planning for our future. Understanding that these situations are outliers and extremes, seeing these major happenings can help us understand the true potential of an investment vehicle, both good and bad.
Historical Moments for Bonds
There are several times in history where bonds have been far from the “boring” investment product. The product is relatively simple, but the backstory is anything but!
Kings and nobles created bonds as a way to borrow money from citizens. If a monarch needed supplies or troops, he could sell bonds at a discounted rate to citizens who wanted to help out. If the citizens purchased enough bonds, the king could purchase supplies and have an army when he needed it.
There are several times in history when bonds provided a significant return. In 1981, bonds offered returns as high as 15%. In 1998, bonds were yielding more than 10%.
On the flip side, there are also times where bonds have lulled. For example, during the stagflation of the 1970s, bonds saw losses as high as 18%.
We often hear of bonds as being an incredibly stable, low-risk/low-reward financial instrument. And, broadly speaking, they are. However, the world of finance and economics can be much more interesting than the broad generalizations that form the bedrock of sound financial advice.
Historical Moments for Stocks
The 1929 Wall Street Crash is perhaps one of the most famous historic moments in stock market history. The term “crash” has become synonymous with the biggest one-day loss that the stock market has ever seen.
The final day, Black Thursday, saw the Dow Jones Industrial Average lose 11% of its value as stocks plummeted throughout the day. By the end of the week, stocks had lost more than 30%, erasing $30 billion in market value and sending the U.S. into a financial tailspin that would last for years after the crash had ended.
The 2008 Financial Crisis is much more recent, but we still feel its impact worldwide. In one of the most severe economic downturns since the Great Depression, stock markets lost over $10 trillion in value, with the housing market losing trillions of dollars as well.
Most recently was March 16th, 2020. With the world coming to grips with the reality of a global pandemic, markets dropped by 12.93%, the second-largest one-day drop in history. Amazingly, just one week later, on March 24th, 2020, we witnessed the 4th largest single-day gain in history, of 11.37%.
The swings of the stock market are real. While the markets have recovered each time, the stock market is undeniably volatile, and we can be sure we will see more examples of the above in the future.
No one can predict what will happen in the future with any investment vehicle. However, bonds remain a safe bet for those looking to mitigate risk while still having an opportunity for growth that will (ideally!) outpace inflation.
Connect with a trusted financial advisor to discuss how you should include bonds and stocks in your investing strategy. Guidance from a fiduciary financial advisor, a professional bound to act in your best interests, can help you make an informed decision about your investments and your financial future through retirement.
