Stocks vs Bonds

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stocks vs bondsUnderstanding the differences between stocks vs bonds is critical to asset allocation. The allocation between stocks and bonds is one of the most significant indicators of the risks and rewards of an investment portfolio. A stock fund buys shares of publicly traded companies, each share representing a small, fractional ownership interest in the company that issued the shares. A bond fund buys bonds issued by the federal government, state and local governments, corporations and other entities. For a stock fund, think of owning part of a public company. For bond funds, think of lending money in exchange for a predetermined interest rate.

History tells us two things about stocks vs bonds: (1) Stocks are riskier than bonds, and (2) financial returns of stocks are higher than the returns on bonds. To better understand the risks and rewards of stocks and bonds, think of owning a home. The homeowner owns the equity (stock) in the house, and the bank owns the note (bond) from the money it loaned the homeowner to buy the house. Let’s look at the differences between the homeowner and the bank:


Homeowner (stock)
Bank (Bond)
Gets (or loses) any change in value of home Gets interest payments only
Assumes risk the house will go down in value Interest payments not affected by value of house
Assumes risk the house will be damaged Interest payments not affect by damage or even destruction of home
If home is sold, must pay the bank first If home is sold, gets paid first

The last point is important, and is one reason why stocks are riskier than bonds. The bondholders always get paid first, and the stockholders get whatever is left. Now let’s look at some numbers. Here are the annualized returns of U.S. stocks and government bonds during the 20th century as reported in William Bernstein’s, The Four Pillars of Investing:

Now, one could see this chart and decide never to buy a bond fund. After all, why invest in something that returns less than stocks? We examine this question in more detail in the article on allocating assets between stock and bonds, but let me leave you with a chart taken from The Boglehead’s Guide to Investing, which shows various returns from the recent period 2000-2002:


Allocation
Total Gain or Loss
Ending Value of $1,000
100% Total Stock Mkt.
-37%
$628
80% stocks/20% bonds
-26%
$742
60% stocks/40% bonds
-13%
$870
40% stocks/60% bonds
+1%
$1,011
20% stocks/80% bonds
+17%
$1,165
100% Total Bond Mkt.
+33%
$1,335

Tomorrow–Day 2: Large Cap v. Mid Cap v. Small Cap Funds

So as you build your own asset allocation plan, remember that how much you invest in stocks vs bonds is one of the most important investing decisions you will make.

Published or Updated: March 30, 2012
About Rob Berger

Rob founded the Dough Roller in 2007. A litigation attorney in the securities industry, he lives in Northern Virginia with his wife, their two teenagers, and the family mascot, a shih tzu named Sophie.

Comments

  1. moses says:

    hello im moses by name im here to know the differences and similarities between stock exchange market and local market i would be glad if i got the correct answer

  2. moses says:

    im moses by name and iwould like to know the differences and similarities between stock exchange market and local market.

  3. DR says:

    Moses, if I understand your question correctly, there are significant differences between stocks traded on the exchanges/NASDAQ versus Over-the-counter (OTC) stocks. OTC can refer to shares listed on what are called the Pink Sheets, the OTC Bulletin Board, or the gray market.

    Good luck, DR

  4. deji says:

    pls what is the different between stock exchange and a market[i.e a market for selling consumable goods

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