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Why should I invest in bonds when the typical return is lower than stocks?

Jan 12, 2012 by Peter from Brooklyn, NY in  |  Flag
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5 votes

Hi Peter,

The answer to this questions depends on your investment goals as well as your tolerance and capacity for risk. Nothing is free in investing, so seeking additional returns requires you to take increased risks and increase your chances of losing at least some of your principal. While the return on bonds may generally be lower (which, by the way, is not always the case), bonds tend to be less volatile (their prices may not fluctuate as much as stock prices do) and the income they produce tends to be more stable as interest payments are required to be paid by the issuing entity. On the other hand, stocks may provide higher growth potential, however the income you receive through dividends may vary and may even decrease to zero as payment of dividends is strictly up to the management of the company. As the characteristics of stocks and bonds are different, it is generally wise to hold a portfolio consisting of a combination of the two for adequate returns with sufficient diversification and downside protection. If you have any additional questions, please feel free to reach out.

Best, Alex

1 Comment   |  Flag   |  Jan 12, 2012 from Staten Island, NY
Victor Guettlein, CFP®

Excellent!

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Flag |  Jan 12, 2012 near Arvada, CO

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In general, a diversifed portfolio of Bonds will return less than a diversified portfolio of Stocks because Bonds reside higher in the Capital Structure than do Stocks. In other words, most Bonds are safer than most Stocks, and so the long-term expected return from Bonds is necessarily lower. This does not mean that all Bonds are safer than all Stocks! There are plenty of ways to get into trouble (lose money) in Bond investing. In 2011 however, most Bonds performed better than most Stocks, and long-maturity US Treasury Bonds performed the best of all! Most novice investors should probably own a combination of Stocks and Bonds and several other asset classes, as part of a diversified approach. The precise mix is the critical issue.

Comment   |  Flag   |  Mar 28, 2012 from Wayne, PA

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One way to think of this is that often times, bonds zig when stocks zag, and as a result you will typically have lower volatility and more steady returns than an all-stock portfolio. This is important because if you take two portfolios with the same average mean return, the one with the lower volatility will have a higher geometric return. In plain English, a lower volatility portfolio can provide higher compound returns in the long run than a more volatile portfolio. The other advantage of a balanced stock and bond portfolio is that, since the "ride" is likely to be smoother than an all-stock portfolio, you're more likely to stick with a good investment plan during the tough times. If you have the best stock portfolio in the world, but bail out when it drops, like in 2008 or in August and September of 2011, then get back in when the market has gone back up, you will not get the long term returns of those stocks. Buying high and selling low is an investor's worst nightmare. A balanced portfolio of stocks AND bonds can help you stay the course and reap the rewards you deserve.

1 Comment   |  Flag   |  Jan 12, 2012 from Arvada, CO
Gregory Werlinich, MBA

What Victor said is basically correct. I would only add that you need to be aware of the rates on bonds when you make the investment. With ten year treasuries paying under 2% right now, do you really want to be locking your money up for 10 years only to earn an interest that doesn't even beat the rate of inflation? If rates rise during that 10 years, and you have to sell the bond, you could end up losing quite a bit of money.

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Flag |  Jan 13, 2012 near Port Chester, NY

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Historically (past 25 years) one did invest into bonds to lower risk of the overall portfolio. But with interest rates now at multi-decade lows, risk in bonds going forward will be much greater. As you may know, there is an inverse relationship between the direction of interest rates and bond values. In the mid 1970s it was not uncommon, in that high interest rate environment, to see bonds trading at around 50% of face (maturity) value. Sure, you could hold onto the bond until maturity and receive the face value, but human emotions being what they are in investing..that probably did not happen.

http://davidgratke.com/wp-content/uploads/2012/01/GratkeWealthCycleofEmotion.jpg

Comment   |  Flag   |  Jan 26, 2012 from Portland, OR

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Actually, bond PRICES tend to lead stock prices. It makes intuitive sense; if bond prices are moving higher, it typically means rates are going lower. Lower rates are conducive to economic growth and stocks typically follow bond prices for that reason.

Another point I would bring up is that we are at HISTORICALLY low interest rates. When rates begin to rise, bond prices will fall. Thus, you may want to look at buying variable rate bonds as they offer more price protection in a rising interest rate environment.

Comment   |  Flag   |  Apr 04, 2012 from Orlando, FL

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Given we believe the bond market is over-valued and fixed income investors must redefine what constitutes safety, we can't give a good answer to your question. Though a case can be made for the high yield corporate bonds of selective small cap companies.

Except to say, we agree with Benjamin Graham that you should not have more than 75% of your risk assets in the stock market, no matter how unattractive bond yields may be.

What to do with the 25% that should be in bonds, then? Probably cash equivalents...

Comment   |  Flag   |  Jan 19, 2012 from Bryn Mawr, PA

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For diversification. As Victor points out, Bonds tend to be "Negatively Correlated" with stocks... A fancy way of saying that they usually move in different directions. So adding bonds to your stock portfolio should, in theory, smooth at the humps and bumps ( while also reducing the expected return, as John mentioned) The right mix of stocks and bonds for an investor is idiosyncratic... A fancy way of saying it depends on your situation goals, time horizon and other factors. Best of luck!

Comment   |  Flag   |  Mar 31, 2012 from Port Washington, NY

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