Allocating investments between stocks vs. bonds is one of the most important asset allocation decisions you’ll ever make. Here’s what you need to know.

Understanding the differences between stocks vs bonds is critical to asset allocation. The allocation between stocks and bonds is one of the most significant indicators of the risks and rewards of an investment portfolio. A stock fund buys shares of publicly traded companies, each share representing a small, fractional ownership interest in the company that issued the shares. A bond fund buys bonds issued by the federal government, state and local governments, corporations and other entities. For a stock fund, think of owning part of a public company. For bond funds, think of lending money in exchange for a predetermined interest rate.

Stocks vs. Bonds – The Risk Factor

History tells us two things about stocks vs bonds: (1) Stocks are riskier than bonds, and (2) financial returns of stocks are higher than the returns on bonds. To better understand the risks and rewards of stocks and bonds, think of owning a home. The homeowner owns the equity (stock) in the house, and the bank owns the note (bond) from the money it loaned the homeowner to buy the house. Let’s look at the differences between the homeowner and the bank:

 

Homeowner (stock)	Bank (Bond)
Gets (or loses) any change in value of home	Gets interest payments only
Assumes risk the house will go down in value	Interest payments not affected by value of house
Assumes risk the house will be damaged	Interest payments not affect by damage or even destruction of home
If home is sold, must pay the bank first	If home is sold, gets paid first

The last point is important, and is one reason why stocks are riskier than bonds. The bondholders always get paid first, and the stockholders get whatever is left. Now let’s look at some numbers. Here are the annualized returns of U.S. stocks and government bonds during the 20th century as reported in William Bernstein’s, The Four Pillars of Investing:

Stocks vs. Bonds – The Returns

Now, one could see this chart and decide never to buy a bond fund. After all, why invest in something that returns less than stocks? We examine this question in more detail in the article on allocating assets between stock and bonds, but let me leave you with a chart taken from The Boglehead’s Guide to Investing, which shows various returns from the recent period 2000-2002:

 

Allocation	Total Gain or Loss	Ending Value of $1,000
100% Total Stock Mkt.	-37%	$628
80% stocks/20% bonds	-26%	$742
60% stocks/40% bonds	-13%	$870
40% stocks/60% bonds	+1%	$1,011
20% stocks/80% bonds	+17%	$1,165
100% Total Bond Mkt.	+33%	$1,335

Stocks and Bonds – Where To Buy Them

Purchasing stocks can be done easily through either a broker or a robo advisor. For brokers we’re currently recommending TD Ameritrade – which offers both services, and an easy way of switching back and forth between the self-directed and managed options. To read our full review of TD Ameritrade, click here – or visit their website directly.

If you’re sure you want to go with a robo advisor, M1 Finance is offering a great package. No management fees, a low minimum starting balance, and the ability to pick individual stocks or ETFs. To read our full review of M1 Finance, click here – or visit their website directly.

To buy bonds, visit TreasuryDirect. This government website is kind of ugly but it’s the simplest way of buying government bonds directly from the issuer, Uncle Sam.

Tomorrow–Day 2: Large Cap v. Mid Cap v. Small Cap Funds

So as you build your own asset allocation plan, remember that how much you invest in stocks vs bonds is one of the most important investing decisions you will make.

Topics: Asset Allocation

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