Stocks and bonds each possess their own sets of advantages and disadvantages. Furthermore, each asset class features dramatically different structures, payouts, returns, and risks. Understanding the distinguishing factors that separate these two asset classes is key to building a healthy investment portfolio that thrives over the long haul.
Of course, asset allocation mixes are unique to each individual, based on an investor's age, risk tolerance, and long-term investment and retirement goals.
Key Takeaways
- Stocks offer the potential for higher returns than bonds but also come with higher risks.
- Bonds generally offer fairly reliable returns and are better suited for risk-averse investors.
- For most investors, diversifying portfolios with a combination of stocks and bonds is the best path toward achieving risk-mitigated investment returns.
Buying Stocks Instead of Bonds: An Overview
Stocks are essentially ownership stakes in publicly-traded corporations that give investors an opportunity to participate in a company's growth. But these investments also carry the potential of declining in value, where they may even drop to zero. In either scenario, the profitability of the investment depends almost entirely on fluctuations in stock prices, which are fundamentally tied to the growth and profitability of the company.
A bond is a fixed income instrument that represents a loan made by investors (known as "creditors" or "debtholders") to borrowers, which are typically corporations or governmental entities. Also known as coupons, bonds are characterized by the fact that the ultimate payouts are guaranteed by the borrower. With these investments, there is a concrete maturity date, upon which the principal is repaid to investors, along with interest payments attached to the interest rate that existed at the onset of the loan.
Bonds are used by corporations, states, municipalities, and sovereign governments to finance a multitude of projects and operations. That said, some bonds do carry the risk of default, where it is indeed possible for an investor to lose their money. Such bonds are rated below investment grade, and are referred to as high-yield bonds, non-investment-grade bonds, speculative-grade bonds, or junk bonds. Nevertheless, they attract a subset of fixed income investors that enjoy the prospect of higher yields.
Pros of Buying Stocks Instead of Bonds
The chief advantage stocks have over bonds, is their ability to generate higher returns. Consequently, investors who are willing to take on greater risks in exchange for the potential to benefit from rising stock prices would be better off choosing stocks.
Investors may also wish to consider investing in dividend-paying stocks. A dividend is essentially a distribution of some of the profits that a corporation makes to its shareholders. And any dividends that are not taken may be re-invested in the businessin the form of more shares in a company.
Bonds also pay regular income in the form of interest payments; however, these cannot be reinvested back into the same bond. Interest rates can change over the life of the bond, which creates reinvestment risk, or the risk that new bonds will have lower yields than the ones you are receiving interest from.
Diversifying investments across both stocks and bonds, marries the relative safety of the bonds, with the higher return potential of stocks.
Cons of Buying Stocks Instead of Bonds
In general, stocks are riskier than bonds, simply due to the fact that they offer no guaranteed returns to the investor, unlike bonds, which offer fairly reliable returns through coupon payments. Stocks are inherently more volatile than bonds because in the event of a corporate bankruptcy, bondholders (who are a company's creditors) have priority in being repaid. Meanwhile, owners of common stock are last in line, and can end up with nothing if the company goes bankrupt.
Risk-averse investors looking to safely deploy their capital and take comfort in more structured payout schedules would be better off investing in bonds.
Have Stocks or Bonds Performed Better Historically?
The historical returns for stocks have been between 8%-10% since 1928. The historical returns for bonds have been lower, between 4%-6% since 1928. Over the past 30 years, stocks have returned an average of 11% annually; while bonds have returned just 5.6% per year, on average.
How Much of My Portfolio Should Be in Stocks?
A well-diversified portfolio contains a broad range of holdings across several asset classes. In general, the longer your time horizon (i.e., the younger you are), the more risk you can take on. Therefore a portfolio weighted 80-90% in stocks and the rest in bonds or other assets is bearable. However, as your time horizon shortens, it is recommended to shift your allocation increasingly toward lower-risk bonds and reduce your allocation to stocks.
Why Do Stocks Generally Outperform Bonds Over Time?
Stocks generally outperform bonds over time due to the equity risk premium that investors enjoy over bonds. This is an amount that investors of stocks demand in return for taking on the additional risk associated with stocks. Stocks also benefit from a growing economy. As GDP grows, so too do corporate profits, which are reflected in the prices of stocks, but not typically in bonds (which are essentially loans).
FAQs
Pros and Cons – Bonds vs Stocks
What are the pros of buying stocks instead of bonds? ›
Stocks typically have potential for higher returns compared with other types of investments over the long term. Some stocks pay dividends, which can cushion a drop in share price, provide extra income or be used to buy more shares.
Why might a different person decide to invest in stocks instead of bonds? ›
The chief advantage stocks have over bonds, is their ability to generate higher returns. Consequently, investors who are willing to take on greater risks in exchange for the potential to benefit from rising stock prices would be better off choosing stocks.
Are stocks safer than bonds? ›
Given the numerous reasons a company's business can decline, stocks are typically riskier than bonds. However, with that higher risk can come higher returns. The market's average annual return is about 10%, not accounting for inflation.
What are the pros and cons of buying stocks? ›
Investing in stocks offers the potential for substantial returns, income through dividends and portfolio diversification. However, it also comes with risks, including market volatility, tax bills as well as the need for time and expertise.
How much should I invest in stocks vs. bonds? ›
The rule of thumb advisors have traditionally urged investors to use, in terms of the percentage of stocks an investor should have in their portfolio; this equation suggests, for example, that a 30-year-old would hold 70% in stocks and 30% in bonds, while a 60-year-old would have 40% in stocks and 60% in bonds.
Why are stocks safer than bonds? ›
Bonds are more stable in the short term, but they tend to underperform stocks over the long term. The inverse is true with stocks, which can be volatile -- very volatile during periods of economic uncertainty -- but have been better wealth-generators when held for five years, a decade, or even longer.
Which stock will double in 3 years? ›
Stock Doubling every 3 years
| S.No. | Name | CMP Rs. |
|---|
| 1. | Guj. Themis Bio. | 408.70 |
| 2. | Refex Industries | 168.05 |
| 3. | Tata Elxsi | 7103.70 |
| 4. | M K Exim India | 91.75 |
14 more rowsStocks with good 1 month returns
| S.No. | Name | ROCE3yr avg % |
|---|
| 1. | Hindustan Zinc | 44.68 |
| 2. | I R C T C | 42.13 |
| 3. | Lloyds Metals | 40.92 |
| 4. | Deepak Nitrite | 38.02 |
23 more rowsDisadvantages of investing in stocks Stocks have some distinct disadvantages of which individual investors should be aware: Stock prices are risky and volatile. Prices can be erratic, rising and declining quickly, often in relation to companies' policies, which individual investors do not influence.
Accordingly, McQuarrie found that, while stocks did indeed far outperform bonds between 1942–1981, not only did stocks and bonds produce about the same wealth accumulation during the 150-year period before 1942, but the same held true from 1982–2019 as well.
Should you buy bonds when interest rates are high? ›
Should I only buy bonds when interest rates are high? There are advantages to purchasing bonds after interest rates have risen. Along with generating a larger income stream, such bonds may be subject to less interest rate risk, as there may be a reduced chance of rates moving significantly higher from current levels.
Can you lose money on bonds if held to maturity? ›
After bonds are initially issued, their worth will fluctuate like a stock's would. If you're holding the bond to maturity, the fluctuations won't matter—your interest payments and face value won't change.
When should you not invest in stocks? ›
You're Not Financially Ready to Invest.
If you have debt, especially credit card debt, or really any other personal debt that has a higher interest rate.
Why is it risky to buy stocks? ›
Stocks are much more variable (or volatile) because they depend on the performance of the company. Thus, they are much riskier than bonds. When you buy a stock, it is hard to estimate what return you will receive over time (if any). Nonetheless, the greater the risk, the greater the return.
Should I keep money in stocks? ›
Saving is generally seen as preferable for investors with short-term financial goals, a low risk tolerance, or those in need of an emergency fund. Investing may be the best option for people who already have a rainy-day fund and are focused on longer-term financial goals or those who have a higher risk tolerance.
What are the benefits of investing in stocks? ›
The potential benefits of investing in stocks include: Potential capital gains from owning a stock that grows in value over time. Potential income from dividends paid by the company. Lower tax rates on long-term capital gains.
What are the pros and cons of bonds? ›
Con: You could lose out on major returns by only investing in bonds.
| Pros | Cons |
|---|
| Can offer a stream of income | Exposes investors to credit and default risk |
| Can help diversify an investment portfolio and mitigate investment risk | Typically generate lower returns than other investments |
1 more rowBonds have some advantages over stocks, including relatively low volatility, high liquidity, legal protection, and various term structures. However, bonds are subject to interest rate risk, prepayment risk, credit risk, reinvestment risk, and liquidity risk.
What are the pros and cons of bond funds? ›
Pros and cons of bond funds
| Pros | Cons |
|---|
| Bond funds are typically easier to buy and sell than individual bonds. | Less predictable future market value. |
| Monthly income. | No control over capital gains and cost basis. |
| Low minimum investment. | |
| Automatically reinvest interest payments. | |
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