• A mix of bonds and stocks minimizes risk
• The low-interest phase makes bonds unattractive
• Investors with an affinity for risk can invest 100 percent in equities
Stocks, but also bonds, offer investors the opportunity to invest directly in a single company or issuer. However, this results in very different opportunities and risks for the investor, which must be considered before making an investment.
The basic difference between bonds…
A bond, regardless of whether it is a corporate or government bond, represents a debenture with which the respective issuer collects debt capital from its investors. For this capital, the buyer or the creditor receives a fixed interest rate, which is usually paid out annually. In addition to this annual interest rate, the lender receives the full amount invested at the end of the bond’s term, provided that the respective state or company is not insolvent.
With the help of a bond, an issuer procures debt capital, which, in contrast to the purchase of shares, makes the investor merely a creditor and not just a partial owner.
… and stocks
In contrast, the buyer of a share becomes a co-owner of the respective group. Accordingly, the shareholder owns a fraction of the entire company. In contrast to the placement of a bond, a group issues fresh equity and no borrowed capital by issuing shares.
While the return on a bond comes from the annual interest payments, the return on shares is made up of dividends and price increases. Although price gains can also be achieved with bonds, the repayment of a bond always refers to the original nominal value. In contrast to bonds, shares do not have a fixed term and can therefore remain in the portfolio for life.
The key similarities between bonds and stocks
Despite the fact that investors inject debt into a company by buying a bond and equity by buying a share, both asset classes have a lot in common. Both bonds and shares can be traded on the stock exchange at any time, which means that their price is always determined by supply and demand. Furthermore, bonds and stocks can be kept together in a securities account. This means that both asset classes can also be acquired and traded together in a mixed fund or ETF.
Another similarity between bonds and stocks is the prospect of regular income. In this way, both asset classes can continuously generate profits, either in the form of dividends or in the form of interest payments.
Individual Rights and Risks in Bonds…
With the purchase of a bond, the creditor acquires the right to regular interest payments and the repayment of his capital after the end of the respective term. If the company encounters payment difficulties during this term, the bond creditor, in contrast to the shareholder, will also be served with priority.
This priority treatment is probably the greatest advantage of bonds over stocks. Apart from that, of course, bonds also entail special risks. The priority treatment of the bondholder over the shareholder does not necessarily protect against a total loss. In addition to this issuer risk, bondholders must also accept inflation, interest rate, price and currency risk.
… and stocks
In contrast to lenders, shareholders receive voting rights due to their direct participation in the company, which can be exercised at an annual general meeting. In addition, shareholders are entitled to a part of the profit paid out in the event of a distribution. In addition, in the event of a capital increase, shareholders are entitled to a subscription right, which enables the priority purchase of new shares.
Of course, the classic risks that affect bondholders also apply to shareholders. Due to the higher susceptibility to fluctuations or higher volatility, as well as the subordinate treatment in the event of insolvency, equities nevertheless carry a much higher risk than bonds. Because while the bondholder can be relatively indifferent to the business development of the issuer as long as it is still solvent, the shareholder has a very great interest in the respective company developing well economically. Because only an excellent business model paired with a positive economic development offers the long-term chance of rising share prices.
The mix makes the difference
“The only thing that is free when it comes to investing is diversification,” says Harry M. Markowitz, probably the best-known saying. For the purpose of portfolio optimization, the US economist developed the so-called capital market theory in the 1950s, which deals with the interaction between return and risk.
With the help of this theory, Markowitz was able to show that the risk of an asset class can be minimized if the investor positions himself diversified. “What is free according to Markowitz is not the diversification itself, but the positive effect that investors buy with it. […] By diversifying their capital, investors can on the one hand reduce their risk of loss and on the other hand increase their chances of return,” is the assessment of DWS fund manager Henning Potstada.
However, investors should not only position themselves broadly within one asset class, but also diversify their assets across different assets. “The most important thing when it comes to diversification, however, is the correct distribution of assets across different asset classes, such as equities, bonds, currencies and commodities,” the DWS manager continues.
Accordingly, it can be worthwhile for investors if they fill their securities portfolio with both bonds and shares. However, it is not possible to give a general answer as to which exact division between these two asset classes makes sense. “A universal rule of how an investor should manage their portfolio of stocks and [Anleihen] should structure, there is [..] not. It depends on the person – their investment goals, investment horizon, risk appetite and age,” Potstada said in a DWS report.
The classic stock-bond rule of thumb is obsolete
The classic equity-bond rule of thumb “100 minus your age”, which is used to calculate the supposedly optimal equity ratio, is well known, but is no longer up-to-date. The formula states that by the time a person turns 30, they should invest 70 percent of their investment capital in stocks and 30 percent in bonds.
However, with a current life expectancy in Germany of 78.6 years for men and 83.4 years for women, a 30-year-old person still has at least 48 or 53 years ahead of them, which makes a 30 percent bond share seem unnecessary. Because for the greater risk that an investor with shares takes on over time, he also receives a so-called share premium, which brings with it a significant difference in return. In addition, it is statistically verified that the world’s major stock indices, such as the S&P 500, have never made a loss within an investment period of around 10 years.
Yield differential between stocks and bonds
Investors who put $1 in long-term US Treasuries between 1925 and 2005 made a total of about $71 after 80 years, which equates to an annual nominal return of 5.5 percent. However, investors who put their US dollars into an S&P 500 ETF during this period would have been worth $2,658 with an annual nominal return of 10.4 percent. Of course there were no ETFs in 1925, but the enormous difference in returns shows what long-term opportunities the stock market offers compared to the bond market.
Due to this fact, investors should not shy away from a high share quota. In addition, the current phase of low interest rates means that bonds with a good credit rating, even without taking the inflation rate into account, represent a predictable loss for creditors.
In this context, André Kostolany very aptly summed up the eternal dilemma between security and yield or equities and bonds in one sentence. “Those who want to sleep well buy bonds, those who want to eat well buy stocks,” said the stock market speculator who died in 1999.
Pierre Bonnet / finanzen.net
This text is for informational purposes only and does not constitute an investment recommendation. finanzen.net GmbH excludes any claims for recourse.
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