Over the last few years, several new asset classes, especially cryptocurrencies, have gained traction. Historically, bonds, stocks, and real estate have been the most popular assets. Many investors want to know if they should invest in bonds or stocks now. What are the risk and return payoffs of investing in stocks and bonds and what role does asset allocation play?
First, let's understand the difference between stocks and bonds. Bonds can be issued by either public or private institutions. Whenever a company needs cash, it can either do so by selling shares or raising a loan. Buying stock gives you an ownership stake in the company. However, as bondholders, you have the first right to the company’s assets.
Are bonds or stocks riskier?
Bonds are considered a safe investment, but they aren't risk-free. First, you take the credit risk when you buy the bond. The bond’s credit rating is a good framework to understand the risk. Lower-rated bonds have higher credit risk and vice versa.
Even if you buy the highest-rated bonds, you are subject to interest rate risks. The price of bonds moves inversely to the interest rates and bonds tend to fall in a rising interest rate environment. Rising inflation and fears of a rate hike led to a rise in bond yields and bonds turned negative for the year.
As for stocks, there are multiples risks. Apart from the company-specific factors, macro factors including the interest rate environment impact stock prices. Earlier in 2021, there was a bloodbath in growth stocks amid the rise in bond yields.
Meanwhile, one apparent risk of investing in bonds is that over the long term, your returns would be lower than that of the stock markets. There have been instances where returns from bonds have even been lower than the inflation rate. Berkshire Hathaway chairman Warren Buffett hates bonds for a reason.
Asset allocation between bonds and stocks
Meanwhile, this doesn't mean that you shouldn’t invest in bonds. Bonds or for that matter fixed income assets should be a part of your portfolio. The asset allocation between debt and equity would depend on your risk appetite and investment objectives. If your investing goal is several years out, bonds won’t make sense for you. However, if you need the funds within a few years, short-term bonds would be apt.
Should you buy bonds or stocks now?
Let’s look at the current macro picture. The yields on bonds have come down due to fears of a growth slowdown. If the economic growth slows down, the Federal Reserve would find itself constrained to raise interest rates. Growth fears have also taken a toll on stock markets and we saw a fall in cyclical stocks. However, stocks bounced back.
The yields on bonds have come down from the 2021 peaks that make bonds less attractive. If you are looking at tactical asset allocation, stocks look more attractive than bonds now. From a strategic asset allocation perspective, some allocation to bonds is always advisable. While things are looking decent for the economy, the unpredictable nature of coronavirus would warrant some allocation to bonds as well as other safer investment avenues like gold.