Stocks Vs. Bonds: Risk-Reward Comparison
By: Flabia Maharjan
The level of risk you’d like to undertake as an investor determines the return you get. In other words, you could either minimize risk to achieve a fixed level of desired return or maximize return with a fixed level of risk. Risk varies with the financial instruments you choose to invest in, among which stocks and bonds are two popular instruments. Before moving on to compare the risk and reward while investing in the two, let us know the key differences between stocks and bonds.
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Owner Vs. Lender
Purchasing stocks means holding ownership in the company while purchasing bonds signifies that you are lending to the company rather than owning it. Therefore, when you own a company’s stock, you are a shareholder and a legal owner of the company. In contrast, when you are a bondholder, the issuer of the bonds is liable to pay you periodic interest along with the principal amount after reaching the bond’s maturity date. Thus, a bond is a loan from you to the company or the government.
Capital Gain Vs. Fixed Income
To earn money from stocks, you’ll have to sell them at a price higher than your purchase price. The profit, also known as capital gain, is earned through an increase in the capital asset value and realized when the capital asset is sold. Capital gains can be used for reinvestment purposes and are subject to tax.
You can earn regular interest payments by investing in bonds. However, the distribution of interest may vary upon the type of bond (corporate bonds, government bonds, treasury bills) you have purchased. It could be semi-annually, quarterly, monthly, or at maturity. Although you can sell bonds in the market to benefit from capital gain, predictable fixed income is why investors are attracted to this instrument.
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Risk and Reward
Stocks: High-Risk High-Reward
Investing in growth stocks means your goal as an investor is to benefit from the increased stock prices. However, we must remember that investing in growth stocks possesses a potential threat since the stock market is volatile, and the stock prices could plunge at any moment. You do not want to sell your stocks without booking a profit. So, the time frame to achieve growth could be higher, but there could arise a situation such that the stocks you’ve purchased never rise in value. But fluctuation in prices can also be one of the pros. The rewards while investing in growth stocks could be huge. If the price skyrockets, you can exit by making a tremendous profit. This explains why stocks have been categorized as high-risk high-reward investments.
Dividend stocks could be a better option to invest in if you are looking for stable returns and high liquidity. The risk would be lower because you’re looking for fundamentally strong companies. However, the returns can be lower than the returns from investing in growth stocks. This is because companies that focus on dividend payouts are not targeting aggressive growth by investing money in growth. As a result, the stock prices may not rise as high or as quickly as companies that do focus on growth.
Bonds: Low-Risk Low-Reward
The reason bonds are categorized as low-risk low-reward investments is because the return is well known to the investor. You have signed up for regular interest payments that can become a source of fixed income for a long period. Bonds have pre-determined coupon rates and maturity dates that help investors access the return on their investment that is uncertain in the stock market. Predictable and stable return translates to low risk. Although bonds may be safer investments in terms of price volatility, it is not entirely risk-free.
The primary risk of investing in bonds is the risk of default. If you happen to purchase bonds of a company that has a high probability of going bankrupt, you are neither going to receive interest payments nor are you getting your original investment back.
Another risk while investing in bonds is a fall in bond prices. Bond prices fluctuate with changes in the interest rates. An increase in interest rates will cause the bond price to fall because investors will be attracted to invest in securities that provide higher interest than rely on lower coupon rates. Lower demand for bonds and sturdy selling pressure will result in downward price pressure. Sometimes you might want to exit an investment but lower bond prices could potentially cause you losses.
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Stock/Bond Portfolio Allocation
If the question is whether to invest in stocks or bonds, the answer is to invest in both. A diversified portfolio includes stocks for huge potential gains and bonds for stable growth and protection against market volatility.
A strategy to consider is the ‘Age Allocation Strategy’. It helps determine how to allocate stocks and bonds in our portfolio. As per this strategy, the percentage of bonds in our portfolio should equal our age, and the percentage of stocks in our portfolio should equal 100 minus our age.
So, if your age is 20, 20% of your investment money should be used to purchase bonds and 80% to purchase stocks. The reasoning for this is when we are young, we tend to have a high-risk tolerance. Investment gains have more time to compound, and we still have time if we are to suffer from potential losses. So, a high-risk high-return strategy is believed to be a favorable one.
If your age is 60, 60% of your portfolio should constitute bonds, and 40% of your portfolio should constitute stocks. The reasoning for this is when you get older, you will have lower risk tolerance. As you approach retirement age, you need stable investments, so you can invest in bonds that have lower volatility and risk.
The strategy is to invest in stocks when we are young and in bonds when we are old. This way, exposure to risk will decline as we age because we will rely more on bonds with stable returns rather than stocks that are subject to market volatility.
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