Friday, March 6, 2009

Stocks have higher return than bonds

Two of the most common investment instruments are stocks and bonds. On average stocks have yielded greater return compared to stocks. So for a long term investor it makes sense to invest in stocks instead of bonds. However the higher return come at a price. Stocks are more volatile and risky while bonds are more secure and their values change less.

Bonds are debt instruments that are repaid at a fixed interest rate. They are issued by companies, governments, municipalities and so on. You are guaranteed to recover your principal together with some interest. The interest cannot change a lot. Unless you sell the bond before its maturity so that you can get a profit greater that the interest rate you initially bought the bond with. However the profit is only a tiny amount greater than the amount you would have obtained had you hold the bond to maturity.

Stocks are however partial ownership in a company and this give you a right to the profit of the company. Hence you get you return either by dividend which is a part of the profit of the company and partly from increase in the value of the shares. As a result if your company is successful the value of the shares and the dividends will increase with time. Hence on the long run the return of stocks has always been greater than the return of bonds.

However on the downside when investing in stocks you are taking a greater risk since the profit of companies cannot be predicted. The company can be highly profitable at a time and make a loss at other times. With this greater risk come the possibility of greater return. However the long term trend of the economy is up and as a result the total profit of the companies will always be up even though a few companies here and there might go bust. Combine this greater return possibility with a good diversification plan and you will see that on the long run stocks will definitely outperform bonds even if you make a loss in one or two stocks.

Stocks are also better able to keep up their values in inflationary time. The value of stocks can increase with time while the principal +interest of bonds can have some difficulties to keep up with inflation.

Conclusion
Bonds are generally associated with certainty and less risk as a result the return is certain and as a result it would be less than that of stocks since they are riskier and more uncertain. They should therefore have greater return. Thus depending on your strategy, risk tolerance, age and plan you could invest in bond alone, in bonds and stocks or in stock alone.


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