Why stocks usually outperform bonds

Stocks offer greater return potential than bonds, but they are more volatile in the process. The issuance and sale of bonds is a “safe” alternative to the general turbulence in the stock market. Stocks involve greater risks, but there are also opportunities for greater returns.

Key points

  • Over time, bond interest rates are lower than the general return of the stock market.
  • Individual stocks may perform significantly better than bonds, but they also face a higher risk of loss.
  • On average, bonds are always less volatile than stocks because of a greater degree of understanding and certainty about their income streams.
  • More unknowns surround the performance of stocks, which increases their risk factors and volatility.

More risk equals more reward

Taking stocks and bonds in the real world as examples, you can think of bonds as loans in essence. Investors loan funds to companies or the government in exchange for a bond that guarantees a fixed return, and promise to repay the original loan amount, which is the principal, at some point in the future.

Stocks are essentially part of the company’s ownership, giving shareholders the right to share in possible and accumulated benefits. Some of the proceeds may be paid immediately in the form of dividends, while the rest of the proceeds will be retained. These retained earnings can be used to expand operations or build larger infrastructure, enabling the company to generate greater future earnings.

Other retained earnings may be reserved for future purposes, such as repurchasing company stock or making strategic acquisitions of other companies. Regardless of usage, if earnings continue to rise, stock prices will usually rise.

Historically, stocks have returned higher returns than bonds, because if the company goes bankrupt, all shareholders’ investments will lose more risk. However, when a company performs well, despite this risk, stock prices will rise, which can even be beneficial to investors. Stock investors will judge the amount they are willing to pay for stocks based on perceived risk and expected return potential-the return potential is driven by earnings growth.

Reasons for fluctuations

If a bond pays a known fixed rate of return, what causes its value to fluctuate? Several interrelated factors affect volatility.

1. Inflation and the time value of money

The first factor is expected inflation. The lower or higher the inflation expectations, the lower or higher the return or yield required by bond buyers, respectively. This is because of a concept called the time value of money. It revolves around the realization that the value of a dollar in the future will be lower than today, because over time, its value will be eroded by inflation. To determine the value of the dollar in the future in today’s way, you must discount its value at a certain rate over time.

2. Discount rate and present value

Therefore, to calculate the present value of a particular bond, you must discount the future payments of the bond in the form of interest payments and principal returns. The higher the expected inflation, the higher the discount rate that must be used, and therefore the lower the present value.

In addition, the farther the payment is, the longer the discount rate will be applied, resulting in a lower present value. Bond payments may be fixed and known, but the changing interest rate environment makes their payment flows subject to changing discount rates, resulting in constant fluctuations in the present value. Since the original payment flow of a bond is fixed, changes in bond prices will change its current effective yield. As bond prices fall, effective yields rise; as bond prices rise, effective yields fall.

More factors affecting bond value

The discount rate used is not just a function of inflation expectations. Any risk that the bond issuer may default (fail to pay interest or return the principal) will require an increase in the discount rate used, which will affect the present value of the bond. The discount rate is subjective, which means that different investors will use different interest rates based on their inflation expectations and risk assessment. The present value of the bond is the consensus of all these different calculations.

The return on bonds is usually fixed and known, but what is the return on stocks? In its purest form, the related return on stocks is called free cash flow, but in practice, the market tends to focus on reported returns. These incomes are unknown and variable. They may grow rapidly or slowly, never grow at all, or even shrink or become negative.

To calculate the present value, you must make a best guess about these future benefits. What is more difficult is that these incomes have no fixed life span. They may last for decades. For this constantly changing expected revenue stream, you are applying a changing discount rate. Stock prices are more volatile than bond prices because the calculation of present value involves two constantly changing factors: income flow and discount rate.

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