Equities versus Bonds

Tuesday, October 29, 2013

Equities versus Bonds

Which is Better

For the purpose of clarification, we will define equities as shares in publicly-listed and traded companies (i.e. Stocks). Bonds may also be bought from public companies but could simply be government bonds bought from the government. Both stocks and bonds have their advantages and disadvantages. Usually investors will find a balance between stocks and bonds, to balance out their risks and returns.

Benefits of buying stocks

Stocks generally deliver significantly higher returns than bonds and often beat inflation. The compounded annual growth rate (CAGR) of the S&P 500 from 1970 to 2012 was almost 10%. If you are able to keep equities in your portfolio for long periods of time, preferably in long-established and less volatile companies, your portfolio will likely see higher growth rates if it is invested primarily in stocks.

If you lack the time to do the necessary research, you could just buy into one of the various stock market index funds. These are actually known as exchange traded funds (ETFs), a common one being SPDR S&P 500 Trust ETF. If you buy this particular ETF, your holding will generally track the growth rates of the S&P 500 index, which makes life a lot easier for many investors.

Why Bonds

For the risk-averse though, investing in bonds are usually the better option, particularly for the older investors who are closer to retirement. If you buy highly-rated bonds (AAA/Aaa-graded by credit rating agencies), the risks will be minimal but so will the rewards, with CAGRs typically sitting closer to 5% than 10%. With bonds, interest payments are made usually twice a year with the principal returning to the investor upon the maturity date (provided that the bond doesn’t default). Government bonds are generally considered being the safest types of bonds, with high-grade corporate bonds coming in second.

In simplistic terms, bonds serve as a safety net for investors, against the riskier stock market. On the other hand, stocks offer investors higher rewards and a hedge against inflation. Conventional wisdom says that finding a balance between both of these financial instruments is optimal for investors.

Finding the right combination is difficult. More conventional says you should subtract your age from 100 to get your stock/equity ratio for your portfolio. For example if you were 30 years old, you would subtract 30 from 100 to find 70, which would mean that 70% of your portfolio should be in stocks, with the remaining 30% in bonds. However, this is just conventional wisdom. You need to make sure not to spend too aggressively when you are young, simply because retirement seems a long way off. There is a time value of money; if you make large losses early on, you will miss out on many years of more conservative compounding.

The sentiment is admirable though. The older you are, the more risk averse you should actually be. Remember, low-grade (and junk) bonds can be extremely risky and rewarding too, just as stocks can be on both ends of the spectrum. Your choices will ultimately dictate your returns, not the types of financial instruments you are working with.

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