Understanding 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:
|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:
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.