Stocks and Bonds
Investing begins by deciding how much money to allocate and which asset class you’d like to invest that money into — whether that be term deposits, property, bonds, stocks, or precious metals. This process is called asset allocation.
Investing across a range of these asset classes helps diversify your portfolio.
Out of these assets, stocks and bonds are two of the most traded, available for purchase on multiple platforms.
Bonds are usually categorised as defensive assets with a low-to-moderate risk profile. Stocks, on the other hand, are classed as growth assets with a higher risk profile.
Let’s examine further the characteristics of stocks and bonds and their differences.
Shares and bonds
Investing in stocks and bonds need not be an either/or exercise: we’ve all been lectured on the benefits of diversification.
For instance, in 2017 Vanguard — a pioneer of ETF passive investing and one of the world’s largest investment firms — published a paper which found that for investors with broadly diversified portfolios, asset allocation was the ‘primary driver of return variability.’
Assessing the returns of more than 300 fund managers across 20 years, the study found that asset allocation was responsible for 90% of a diversified portfolio’s return patterns over time.
That means market timing and securities selection (identification of individual securities in a given asset class) together accounted for the remaining 10%.
What does this all mean?
Deciding on a mix of appropriate assets to invest in should be one of our first decisions as investors.
As chief investment officer of Mercer Australia Kylie Willment noted, asset allocation is ‘your single biggest decision you have to make as an investor.’
That’s why it could serve you well to learn about asset classes other than just shares. After all, a healthy portfolio may very well include both stocks and bonds.
That said, there could be those who don’t have a cash pile high enough to be spread across multiple asset classes, and who wish to understand the differences between them before committing their money to a particular one.
But before we get into the details of stock and bond investments, here is a quick refresher on these common asset classes.
Breaking down stocks
The stocks of a company are traded through the buying and selling of shares.
When we hear the word ‘share’ bandied in a financial context, we don’t refer to kindergarten manners.
We refer to financial instruments with potential to generate wealth. We see shares as a line on a graph that — ideally — creeps higher (but not always, of course).
But those kindergarten kids might be on to something as well…
See, when we buy a company’s shares, we are in fact buying part ownership of that company. So, we’re sharing their success: we’re getting a slice of their pizza.
Unfortunately, we’re also sharing their failures. If the pizza falls on the floor, we get nothing — even though we chipped in for it. We could also lose part or all of it.
The trick is to invest in the companies that know how to hold a pizza box properly.
Staying on this pizza metaphor, sometimes a company really wants to start catering, but they just don’t have the dough — pun completely intended.
In this case, they might issue a bond. This is a fixed-income investment, where the investor lends money to an entity to borrow.
An interest rate is agreed upon, as well as a time frame within which the loaned funds must be returned. This is called the maturity date.
Investors can use bonds to construct a well-rounded, secure portfolio, provided they make the right calls.
You should also be aware of the risks associated with bond investing, such as interest rate, and default risks.
Stocks and bonds investment
So, how do stocks and bonds compare as investments?
The brief answer lies with risk appetite and investment horizons.
Generally, bonds are considered lower-risk investments, while some shares offer potential for higher returns but also higher risk.
The higher risk of shares can translate, on average, to higher potential returns — investors expect higher returns for taking on higher risk.
The 2020 Vanguard Index Chart — which charts market returns for several asset classes over the 30 years from July 1990 to June 2020 — showed that $10,000 invested in particular Australian shares in 1990 became $130,457 in 2020.
As for particular Australian bonds, $10,000 invested in 1990 became $93,545 in 2020.
On average, Australian shares rose 9.6% per year during the period.
Australian bonds rose 7.9%.
Highlighting their greater volatility, the best year during the period for Australian shares saw gains of 30.3%, and losses of 22% in their worst year.
In contrast, the best year for Australian bonds saw gains of 22.4% and losses of only 1.1% during the asset’s worst-performing year.
Stocks are typically traded on various exchanges while bonds are usually sold over the counter, rather than in a centralised place.
The bond market comprises longer-term borrowing or debt instruments than those that trade in the money market.
The bond market includes financial products like Treasury notes and bonds, corporate bonds, municipal bonds, mortgage securities, and federal agency debt.
Sometimes, these are called fixed-income instruments because they promise either a fixed stream of income or a stream of income determined according to a particular formula.
In practice, however, these formulas can result in a flow of income that is far from fixed.
Therefore, industry professionals sometimes prefer simply to call these types of financial products either debt instruments or bonds.
What are the differences between stock and bond markets?
Mainly, risk. Any stock investing carries risk, which you should fully appreciate before investing.
Stock markets are more susceptible to geopolitical risks, currency risks, liquidity risks, and interest rate hike risks.
Bond markets, conversely, are more susceptible to inflation and interest rate risks. For instance, rising interest rates usually correlate with falling bond prices.
Stocks and bonds news
Here at Money Morning, our job is to make sure our readers are given the right information and the right advice for investing in stocks and bonds.
And we don’t stop there.
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