Learn the pros and cons of investing in bonds vs stocks and how you can build a diversified portfolio.
Many investors swear off stocks, saying they’re too risky, and opt exclusively for bonds in their investment portfolio. The conventional wisdom is that stocks are simply too volatile for conservative investors. But for investors with a long time frame, avoiding stocks is a mistake that is costing them hundreds of thousands of dollars over an investing lifetime, if not more.
Here’s why stocks can be a much safer investment than bonds in many scenarios, and why you’ll want to own at least some stocks in your portfolio.
Why bonds are not so safe after all
Much of the investing public believes that bonds are the “safe” investing vehicle, while stocks are the dangerous or high-flying asset that usually burns investors. Bonds promise a regular payment of interest and then when the bond matures investors receive their principal back and can invest in something else. Stocks make no such promises.
A well-diversified portfolio of stocks and bonds makes great addition to any portfolio, because it increases the average return, adds diversification, and smooths out the portfolio’s returns.
Unfortunately, too many people have limited experiences with stocks so that one bad experience drives them away from the asset class entirely. But bonds are not always a safe investment either, and here’s where you need to watch out.
Buying bonds in a booming economy
The price of bonds goes down when interest rates go up. That’s because rising interest rates make the bond’s future interest payments worth less in today’s dollars. When do interest rates rise? When the economy comes out of a recession and begins to grow. It’s at this point that the Federal Reserve begins to raise interest rates and the market begins to price in higher long-term rates. As long as rates continue to rise, bond prices will likely continue to fall.
If you need to sell your bonds at this point, you’ll likely have to sell them at some discount to their face value.
Buying long-dated bonds
Buying bonds while rates are rising can be dangerous, but if you’re buying short-term bonds (less than a few years until maturity), you’re not going to feel the pinch too badly. The price of short-term bonds won’t dip much in response to rising rates, because the bond’s interest payments are not far in the future.
What will get hurt, though, are long-term bonds (more than 10 years to maturity). Because the interest payments are so far in the future, a change in today’s interest rate drastically hurts the current value of those future cash flows. The longer the bond, the worse the hurt, all else equal.
Bonds will get destroyed if inflation gallops ahead. An inflation rate of 2%-3% may not be so bad and it’s a relatively normal rate, but investors with bonds earning interest of 2%-3% will completely lose purchasing power over time if inflation remains there. And if the rate kicks up even higher, say, 4%-5%? Then a whole swathe of bonds could be hit hard. If inflation stays that high, it’s going to be tough for investors to get purchasing power back over time.
So in essence, inflation eats the value of an investor’s interest payments. And even if you’re earning 5% on a bond (not too bad today) and inflation comes in at 3%, you’re gaining only 2% in purchasing power annually. That’s very little.
These are significant problems with bonds, which typically pay a fixed level of interest for the life of the bond. If retail prices go up, well, that’s tough, because the bond won’t pay any extra interest to compensate you for the increase. And that’s why you need stocks in your portfolio.
Why stocks are safer than you think
Stocks can be a lot safer than you think. But let’s be clear: there are plenty of stocks that are risky and not worth investing in and that will lose money. However, a properly diversified portfolio of high-quality stocks will perform well over time, though stocks may still be more volatile than a portfolio of only bonds.
The easiest portfolio of high-quality stocks to buy is a Standard & Poor’s 500 index fund, because you can get immediate exposure to 500 of the top companies and immediate diversification. The index has risen an average of 10% annually.
Why you need stocks in your portfolio
There are many reasons why you should include stocks in your investment portfolio.
Stocks perform well in a booming economy
Just when bonds are performing poorly, stocks tend to be doing well. In a booming economy, consumers are out spending, businesses are out investing, and profits are rising. Investors are happy because profits are rising, and they push up stock prices. And this cycle usually goes on for at least a few years, while the economy is expanding.
Buying Stocks Gives You An Ownership Interest in the Business
A lot of people think stocks are just wiggling prices on a computer screen, but they’re actually an ownership interest in a business. And what a stock tells you is how much investors as a whole are valuing that company. Investors appraise a company as the value in today’s dollars of all its future cash flows. That sounds like how investors value bonds, and it is.
However, there’s a key difference. Because the value of stocks is based on a company’s profits and a company’s profits can rise, the stock can become more valuable in the future and that separates a stock from a bond. So the trick is finding companies whose profits can rise.
Stocks Protect Against Inflation
Because a company’s profits can rise over time, a portfolio of stocks such as the S&P 500 can protect your purchasing power over time. If the average return of this index fund is 10%, then inflation of 2%-3% still leaves a lot of growth (7%-8%) in purchasing power each year. Meanwhile many bonds are hurt. And if inflation rises further? The best companies are able to raise their prices as inflation rises, offsetting its effect. But bonds are still getting hammered.
Risks of Investing in Stocks
The riskiness of stocks has been overstated, and it’s fair to say that not having stocks in your investment portfolio is more dangerous than owning them. Inflation can ravage an all-bond portfolio, and as we’ve seen in since the Great Financial Crisis of 2008-2009, investors will stretch for yield, even buying dangerous bonds because it’s their only option to generate income.
But when contemplating adding stocks to your portfolio, it’s important to keep certain things in mind.
Pay attention to your time frame
Because they’re more volatile, stocks need more time to go up, so any money you need in the next two or three years should not be in stocks. Bonds tend to be less volatile and they tend to fluctuate less as they near maturity, so they’re a better option for near-term money. But the longer the investing horizon, the greater the need for stocks in your portfolio.
Stocks can be only part of the portfolio
While stocks can be great for a portfolio, investors don’t have to go all stocks all the time, either. A well-diversified portfolio of stocks makes a great addition to an all-bond portfolio, because it increases the average return, adds diversification, and smooths out the portfolio’s returns. In other words, stocks do well when bonds do ok or poorly.