By: John Kolb

“Which is better, stocks or bonds?”

“I’m worried about the stock market — should we just move entirely to bonds?”

“Why should I be in bonds at all when stocks have performed so much better?”

Here at Hudock Capital, we often hear these types of questions from investors.  And let’s be clear: These are good questions to ask, because the decision of where and how to invest your money is one of the most important you can make. 

Recently, the last question is the one we tend to hear the most.  Many investors, when they compare how stocks have performed in recent years versus bonds, are wondering why they should own bonds at all.  Since the end of the Great Recession, stocks have significantly outpaced bonds in terms of total return.  So, if stocks provide a greater return than bonds do, aren’t stocks simply better? 

The problem with this kind of thinking is that it can lead to something behavioral scientists call the false dilemma.  This is a type of fallacy where a person needlessly limits their decision-making to a single binary choice, even though other options exist.  It’s a particularly dangerous thing to do with your money, because investment decisions should be based on a whole range of factors: Your goals, your timeline, your tolerance for risk, how much you have to invest, and more.  The question of “Which type of investment made more money in a given period” is just one factor to consider…and it’s why, here at Hudock Capital, we never think of different types of investments as being “better” or “worse” than others. 

Instead, we focus on which types of investments are right or wrong for you. 

To illustrate what I mean, let’s take a look at how stocks and bonds actually work.  As you probably know, when you purchase a bond, you are essentially loaning money to a company, government, or organization.  When you buy stock, you are purchasing partial ownership in a company.  For this reason, stocks are equity investments while bonds are debt investments.  But what does that actually mean?  Let’s take a closer look.

How Stocks Work

When you buy a company’s stock, you buy a share in that company – and the more shares you buy, the more of the company you own.  Generally speaking, stocks can be held for as short or long a time as you wish, but most investors hold onto their shares for the long-term, because they anticipate the value of their shares will rise over time. 

This rise is the primary way investors look to make money from stocks: Buying them at one price and then selling them later on, hopefully at a higher price. 

The single biggest benefit to investing in stocks is that, historically, they outperform most types of investments over the long term. Because stocks represent partial ownership in a business, finding a strong company that performs well for years can be a powerful way to save for the future. Additionally, stocks are a fairly liquid investment. That means it’s easy to both buy and sell them whenever you need cash.  Many other investment types, like bonds, can be difficult or costly to sell, essentially locking you in for the long term.

But these benefits are just one side of a double-edged sword. You see, with the possibility of a higher return comes added risk. While the stock market does tend to rise over time, individual stock prices can be extremely volatile, climbing and falling daily, sometimes dramatically. If a company underperforms relative to its expectations, the stock price can go down. Sometimes, companies can even fail altogether, and it’s possible for investors to lose everything they put in. As the saying goes, risk nothing, gain nothing — but it’s equally true that if you risk too much, you leave with less.  Furthermore, to actually realize any gains you’ve made, you must sell your stock, which can trigger a significant tax bill.

None of this means you shouldn’t invest in stocks — just that you need to be careful about the potential consequences.  For example, if all of your money is in stocks, and the stock market drops 20% or more, it can take a long time to regain what you lost.  And since you must sell your stock in order to realize your gains, if the market falls just when you need your money most — like, for example, when you are about to retire — it can have a devastating effect on your financial goals. 

Because of these potential downsides, it’s usually a good idea to diversify your portfolio among different types of assets.  And of all the various asset classes out there, bonds are often one of the most useful.  Here’s why:

How Bonds Work

Bonds can also rise in value and be sold for a profit, but generally speaking, that’s not what most investors are looking for.  Instead, bondholders are hoping for something a bit more predictable: Fixed income in the form of regular interest payments. 

As previously mentioned, bonds are a loan from you to a company or government.  That loan might last days or years – sometimes even up to 30 years – but when the bond matures, the company pays back your initial investment.  In the meantime, the company also pays you regular interest, just like you would when you take out a loan.  Depending on the type of bond you buy, these payments can be annually, quarterly, or monthly.  Interest payments are why investors often look to bonds as a source of income.

But income isn’t the only “pro” when it comes to bonds.  Bonds tend to be much less volatile than stocks.  There are two reasons for this.  First, investors tend to hold onto their bonds for the long-term, because they want to receive regular income payments and recoup their principal when the bond matures.  As a result, you don’t usually see bonds traded back and forth the way you do with stocks. 

Second, many bonds tend to be issued by stable, mature companies — these are known as investment-grade bonds — or by local and federal governments.  For example, U.S. treasury bonds are issued by the U.S. Department of Treasury on behalf of the federal government.  They carry the full faith and credit of the government, which has historically made them a very stable and popular investment.  In fact, U.S. treasuries tend to be so stable that economists often use them as a bellwether for the overall health of the entire economy. 

Another advantage of bonds: Since the company that issued the bond is technically in your debt, you would be among the first in line to get at least some of your money back even if the company enters bankruptcy.  That’s not the case with stocks.

Now, bonds come with their own downsides, too.  As we’ve already discussed, bonds don’t have the same growth potential that stocks do.  And just because bonds are less volatile doesn’t mean they’re risk-free.  Bonds may rise or fall in value as interest rates change.  So, for example, if you bought a bond in Year 1 only to see interest rates go up in Year 2, the value of your bond will fall.  That’s because you are missing out on the higher interest rate payments you would have had if you bought the bond in Year 2.  That’s important, because if you wanted to sell your bond before it reached maturity, you would probably have to settle for a lower price than what you initially paid.        

Stocks and Bonds Together

As you can see, stocks and bonds each have different advantages and disadvantages.  That’s why neither is “better” than the other.  It’s also why, for many investors, the real answer is, “Why not both?”  

Far from being competitive, stocks and bonds are actually complementary.  That’s because each brings things to the table the other doesn’t.  Furthermore, stocks and bonds are what’s known as non-correlated assets.  That means they don’t necessarily move in tandem with each other .  For example, say the stock market goes down.  Just because stocks are down doesn’t mean bond values will fall, too.  In fact, they may go up!  (And of course, the inverse is also true.)  This kind of non-correlated movement isn’t guaranteed, but by allocating a portion of your portfolio to both stocks and bonds, we can essentially prevent all your eggs from being placed in one basket.

Bonds can also be a handy tool to help rebalance your stock portfolio.  Here at Hudock Capital, whenever we see a market correction (a drop of 10% or more) or a bear market (a drop of 20% or more), we often look to invest in stocks so we can take advantage when they rebound.  Keeping a portion of a client’s portfolio in bonds not only insulates them from the drop — it gives us something to sell so we have the cash needed to re-invest in stocks and benefit from their recovery.  For example, in 2008, during the financial crisis, the stock market fell by 37%.[i]  During that time, intermediate term treasury bonds were up nearly 18%.[ii]  In a similar scenario, by rebalancing, we can sell some of our bond positions that are up and then invest the money into equities to take advantage of a recovering stock market.

In other words, simply by including bonds in our portfolio, we are able to reduce risk and buy low — exactly what our clients needed most. 

Conclusion

As you can see, the question of “stocks versus bonds” is a false dilemma, and one investors should strive to avoid.  Stocks and bonds both deserve a place in your portfolio if it makes sense for your specific goals and needs. 

Here at Hudock Capital, our process has always been to understand who you are, what you want, and what you need as completely and thoroughly as we can before we make any recommendations.  Once we have that understanding, we work with you to create a plan for reaching your financial goals — a plan that’s specific to you.  Inside that plan, we leave no stone unturned when it comes to choosing the right options for your situation.  So, if you would ever like a second opinion on your portfolio, please let us know.  Our door is always open!  

[i] As measured by the S&P 500 Total Return Index, which measures how all the stocks in the S&P 500 perform while assuming that all dividends have been reinvested. 

[ii] As measured by the iShares 7-10 Year Treasury Bond ETF, which tracks the performance of all U.S. Treasury bonds that mature between seven and ten years.