According to a report by the CNBC, you can expect stocks to outperform bonds 94% of the time. Just in August of 2019, the S&P 500 index yielded a 1.89% increase in its dividend yield. This is far greater than the 1.5% yield of a 10-year treasury. When we say that stocks outperform bonds, we mean it in terms of both, the dividend yield and long-term returns.
In this post, we will compare the two options in detail.
Bonds and stocks are not essentially the same. A company issues a bond when it requires funds. By buying a bond, you’re lending to the company. In return, the company pays you periodic interest installments. This is the same as taking a loan from a friend or a financial institution. In other words, bondholders are creditors for the company.
On the other hand, investing in a share is like being a partial owner of the company. While a bond is an instrument of debt, a share is a certificate of ownership. This means that shareholders have access to and right over a lot of information that bondholders don’t—something that goes beyond monetary benefits.
Stockholders have voting rights over the company. This means that they’re invited to important events that are a part of the decision making process. If the company does exceptionally well in a certain period, the bondholder will receive interest income equal to the coupon value of the bond. On the other hand, a shareholder will be entitled to greater earnings.
The risk/return equation
Stocks carry a higher risk than bonds—this is not necessarily a bad thing. With greater risk, come greater returns.
Let’s talk about the risk first. If a company fails to perform well, the stockholders might not get paid according to their expectations. At the same time, if the company performs well, the earnings of shareholders will exceed the fixed income of bondholders. Thus, the higher expected returns compensate for the risk that the investor is willing to take. The returns of stocks are determined by the earning potential of the company. We agree it could go either way but if the company does well, the returns exceed those of bonds.
This means that stocks are a much favorable form of investment if:
a. You’ve picked the right stock
b. You’ve high risk tolerance
c. You’re looking for long term profits
Stocks also outperform bonds because they can be easily resold. In other words, if you want to pull out your investment, stocks are a more liquid option. We have the stock exchange to thank for this.
The stock exchange is a very well-organized platform for such transactions. The prices of stocks are determined by the market forces. On the other hand, it’s not always easy to determine the prices of bonds. Unlike the stock exchange, there is no easily accessible point where you could read off the prices. You might have to pay a broker to help you out.
Also, you can’t sell a bond back to the company before the maturity date. If you do, you might be asked to pay some penalty or face a loss of income.