Written by Demi Oye
There is a saying that goes thus “Don’t be late, Investing is great”
But when it comes to equities or bonds, conventional sagacity becomes the third wheel.
As investors keep looking for new ways to put their money to work, a frequently asked is “Do equities outperform bonds?”
If you are an investor looking to see which works better for you, looking at the reason behind any accredited school of thought gives more insight.
Bonds are loans given out to finance a project. Equities are stocks and shares with no interest. While bonds are given out at a fixed interest rate, equities depend solely on profit. The pay-back for bonds comes in steadily, while equities can only rely on the market forces for prediction. While bonds are loans, stocks are rights to partial ownership.
According to the risk-return tradeoff, more risk is associated with a higher return. Only if an investor will accept a greater chance for losses will he earn massively in return.
So you may ask again; equities or bonds?
Here’s A Practical Example
Mr. A decides to start a company. He calls his two friends, Mr. B, and Miss C. to invest. Mr. B says he can only afford to loan him some money and get it back at a return rate of 10%. Miss. C decides to buy shares. Mr. B and Miss. C invest the same amount, but in different ways.
At this point, no one knows if Mr. A’s business plan is going to work out or not.
However, all three friends understand the business model. In the first year, Mr. A runs at a loss. He has entered into a legal pay-back agreement with Mr. B, so he has to pay back. Even if he has to borrow, paying back is his only option (interest inclusive). Miss C., on the other hand, does not gain as it appears that she invested in a loser.
Mr. A does not make gains until the fourth year when he makes a 500% gain. While he pays back the same fixed amount he pays Mr. B every year, Miss C’s dividend is far more massive and based on the profit made. She will make far above whatever Mr. A has paid back to Mr. B. If the company’s profit keeps rising, so will her dividend while Mr. B’s pay-back remains fixed.
Just like the example explained; greater risks, higher return.
What stockholders have a potential of earning dwarfs what a bond investment ever earns.
A bond may seem like a safe-haven, but inflation plays a big role to make sure investors do not get the value for their money. What one USD is worth today cannot be the same in three years, and that is another factor—the time value of money. Therefore, if an investor will get their money back with these changes, proper measures and reviews need to be in place. The interest rate policies and environs also change over time, so one must consider the present value to avoid being at a loss. Typically, with a fall in interest rate, bond prices rise. They decline when the interest rate falls. The bond issuer’s credit quality also play a huge role in the returns generated on bonds. For instance, corporate bonds yield more than treasury bonds since treasury bonds are associated with little risk.
The risks carried by equities are quite apparent. The condition of the economy is a significant factor as to if an equity will yield good returns. A rise in interest rate will affect consumer and business behavior and particularly, spending. Thus, corporate profits will be affected. So will the return on equities. On the flip side, a fall in interest rate will favor the economy and spending. This way, higher profits and rise in stock prices will be evident. Competition is also another factor.
However, the right investment in some sectors that are indispensable will bring a steady return on equity. Examples of these sectors are healthcare and technology. A calculated risk in equity will still yield results.
In the end, equities generally outperform bonds. The Standard and Poor 500 market index has shown this in generating a substantial return per year. This rise is significantly higher when compared to the return per year of the US intermediate-term government bonds.
Stocks outperform every other form of investment by far over time. The only exception is if the company in question is a real loser. In the cases of a highly volatile market, investors move from stocks to bonds of high-quality.
Mixing stock and bonds depends on the investment’s tolerance risk. It also depends on the time horizon in investment. The age of the investor is also a factor in many cases, as a younger person still has more time to recover from a significant loss. Senior citizens tend to stick with blue-chip investments and government bonds, to be sure of steady income.
At the end, whatever your portfolio yields will be based on the traditional mix between bonds, stocks, other assets and the condition of the economy.
Investors need to achieve a proper mix to avoid running at a loss.
Sometimes, the problem is not even a loss, but earning lower than an investor has the potential to make.