Stocks vs. Bonds: Risk and Reward
Amy Braun-Bostich, CFP®, CFS®, APMA®, CLTC® was recently quoted in this U.S. News & World Report article titled “Bonds vs. Stocks: Differences in Risk and Reward” and wrote this blog post as a follow-up piece with her full thoughts:
What’s the difference between stocks and bonds?
When you buy a stock, you become an owner of the company. When you buy a bond, you are loaning the company or government entity money for an agreed upon time and rate of interest. When you buy a stock, you have no guarantee that you will make money. The stock could languish for years without growing or it could end up bankrupt. If it becomes bankrupt the stockholder will not get anything including a return of principal. They may have received stock dividends prior to that but most companies that are having financial problems will discontinue stock dividends and some companies do not issue them at all. The same could hold true for a bond except when the bankrupted company is liquidated, the bond holder may get some of their principle back. In addition, the bondholder has been receiving interest on their bonds up until that point.
What should sound investors know about the risk profile for stocks vs. bonds?
Stocks and bonds are evaluated by different organizations for likelihood of viability. Companies like CFRA, Morningstar, and the major brokerage firms rate stocks. In general, they are rated sell, hold, buy or strong buy. There are a variety of versions of this. Zacks uses a numbered system and Morningstar uses a star system to evaluate some assets.
Some stocks are very low risk. They have a proven track record; they most likely pay a dividend, and they move up or down less than the overall market. A stock like Pepsi would fit this description. These are called value stocks and they trade at a reasonable price or below what an analyst believes is a reasonable price, so they represent a good long-term buy. A tale of caution though, some low-priced stocks are low priced because they are not a good buy. Some stocks are in growth-oriented businesses and can represent a large upside potential but may be volatile as their stock price swings up and down. They do not usually issue dividends because they want to reinvest in themselves. Tesla is a good example of this, as are firms in technology, biotech, or disruptive technologies.
Bonds are rated based on the likelihood that the company or government entity can pay back their debt. Firms like Moody’s and Fitch rate bonds on quality. They use letters to rate bonds like A, B, C, D and variation within those letters. An investment grade bond might get a AAA rating from Standard and Poor’s whereas a bond in default may get a D. Bonds are also sensitive to rising interest rates and the longer the term of the bond, the more sensitive it becomes. During the recent rate hikes by the Federal reserve, holders of long-term Treasuries (US government debt), saw 20%+ losses in their bonds.
With both stocks and bonds, the more risk that a purchaser takes, the greater the possibility of higher returns but also a higher chance of failure.
What suggestions do you have for investors who want to diversify between stocks and bonds?
Diversification is an important risk mitigating tool. For most investors, mutual funds or ETFs are diversified vehicles that can help reduce risk by spreading money out over many holdings. Some of these funds mimic indices like the Standard and Poor’s 500 or the Russel 2000, or the NASDAQ. Some funds are actively managed, and in that case, you are buying the capabilities of the manager(s) or the strategy. Trying to pick individual stock or bonds is problematic for most people because they do not have an analytical skill set that’s appropriate to do so.
I recommend a wide range of both stocks and bonds for portfolios. Stocks can be divided into value and growth, market capitalization (size of the company) domestic companies and international companies. Bonds are diversified by short term, intermediate or long-term bonds and domestic or international. They also have investment grade, high yield lower grade, corporate, municipal or government bonds. Municipal bonds are federally tax free and can also be state tax free if you live in the state of issuance. Government bonds can be state tax free.
