When making any type of investment, you always want to get the most bang for your buck. Investing in stocks and bonds is great. Practically speaking, it’s simple: it doesn’t require a lot of capital and you can see the value of your investment daily. However, investing is not for the faint-of-heart. There will be times when your investments lose value—sometimes significantly. So, what can an investor expect as a return on his/her investment? And more importantly, what exactly are the differences between these two investment options?
Buying a bond is similar to making a loan—to the government, a municipality, or a corporation. Bonds pay a fixed interest rate but can also gain or lose value. According to Vanguard, from 1926 to 2015, the average annual return from bonds was 5.4 percent, with 14 of the 90 years resulting in a negative return.
Buying a stock is purchasing ownership in a company in the form of shares. A business can reward its shareholders by paying them dividends—a portion of the business’ profits—which a shareholder can receive in cash, more shares of stock, or additional property. The price of the stock also increases or decreases according to the health of the company. Again, Vanguard reports stocks had an average annual return of 10.1 percent, with 25 of the 90 years resulting in a negative return.
What does this mean for your money? Say you invest $50,000 for 10 years. Using the historical return rates reported for stocks and bonds, your ending balance after 10 years would be:
Invested in bonds at 5.4% per year: $84,601
Invested in stocks at 10.1% per year: $130,870
Equity Risk Premium
As you can see, stocks have traditionally had a much higher return rate than bonds. In finance, we call this the “equity risk premium.” Essentially, you have received higher returns (a premium) as a result of taking on the extra risk of owning stocks (equities).
Is it better to own stocks or bonds? Based on performance, stocks. But aren’t stocks riskier? Can we even compare the two?
Jordan vs. LeBron
Consider the debate of who is the best basketball player—Michael Jordan or LeBron James. Can we compare these two athletes, or are their respective eras different enough that there is no way to objectively liken them? Is it too simplistic to use “number of championships” as a benchmark, much like using annual returns to compare stocks with other investments?
Unlike Jordan and LeBron, there is a distinct way to rival stocks and bonds after adjusting the difference in risk: Sharpe ratio. This measures the excess return of an investment, like stocks, over a risk-free investment, like a Treasury bill. A higher Sharpe ratio would indicate more return for the amount of risk you’re taking. A lower Sharpe ratio would mean you’re not getting the most bang for your buck, considering the amount of risk you’re taking.
Research has shown that the Sharpe ratio for stocks is more than double that of bonds*. Adjusted for the higher risk of owning stocks, the excess return of stocks is larger than bonds. In other words, investors have been rewarded well for taking on the additional risk of owning stocks.
Why is this important?
Wise investors focus on stocks. Fortunately, you don’t need to choose stocks or bonds. Most people fit an appropriate level of both in their portfolios.
Planning for how much you need to save for retirement depends on what you are projecting for your investment returns. Not sure how much you need to save? We can help you plan.
Focus on the long-term, not on news headlines and short-term distractions. Certain stocks may be doing well now based on current financial trends, but it’s important to focus on the overall historical return before making an investment decision.
Don’t mess with financial products that sound too good to be true. Nothing can give you “stock-like returns with bond-like risk.”
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* Marston, Richard (2011) Portfolio Design: A Modern Approach to Asset Allocation. Hoboken, New Jersey: John Wiley & Sons, Inc.
* Marston uses the time period of 1951-2009 to compare the return, standard deviation, and Sharpe Ratio for the S&P 500 and an index of Treasury Bonds.
Disclosures: Past performance does not mean future results will be similar. Different types of investments involve varying degrees of risk. Nothing in this article should be viewed as personal financial advice.