Despite the fact that stocks have historically outperformed bonds over long periods, the savvy investor should still consider bonds as part of a well-rounded portfolio. Comparing the characteristics of the two will show why.
Common stocks represent ownership in a corporation, whereas bonds are literally IOUs, thereby making bondholders creditors of the company. Stockholders, as owners of the corporation, have a claim to income and assets and are entitled to voting rights. However, with regard to income and assets, common stockholders stand last in line in their right to share. Shareholders are entitled to receive dividends only after the bondholders and preferred stockholders have been paid. Similarly, in bankruptcy, the claims of bondholders—as creditors—are settled first, and common stockholders are last for the collection of any remaining proceeds from the liquidation of assets.
A bond has a maturity date, at which time the instrument is paid back at par (face) value, which is typically $1,000 per bond. The longer a bond's maturity, the greater its risk to the investor. Thirty-year corporate bonds, for example, are riskier than 30-year US Treasury bonds because the interest and principal payments for the T-bonds are backed by the US Government. Anything could happen within a 30-year period to force a corporation into bankruptcy before its bonds can be redeemed. However, in the event of a default, the corporate bondholder still has a priority claim over the common stockholder, and the bondholders' claims would have to be paid before any proceeds are paid to the stockholders.
Going further, investors in common stocks aren't guaranteed dividends. Dividends on common stock are declared at the discretion of the company's board of directors. If corporate earnings decline or the board decides to use the money for other purposes, dividends may be reduced or not paid at all. Bond investors, by contrast, can generally count on a steady stream of interest income. Thus, investors who cannot tolerate a reduction or termination of current income should be wary of all but the most stable common stocks.
Historically, investors have been greatly attracted to common stocks for their ability to provide capital growth (which is an increase in the selling price of an asset over its purchase price) over long periods. Bonds, too, offer the potential for capital appreciation; however, investors usually buy bonds primarily for current income.
Also, due to the higher volatility of stocks over bonds, the prudent investor might not want to be overly committed to stocks. During the 70 years since 1926, stocks have been roughly 3 times more volatile than bonds. And as an added advantage, those in high tax brackets may be able to reduce their federal, state and local taxes by investing in municipal and government bonds.
Investing in the stock market does offer the potential for the long-term growth of a portfolio. Investors who have the luxury of a long time horizon (5 to 10 years or more) and don't need the income from their investments may be well served with good stocks. Investing in the bond markets provides for current income. These investments are more suitable for those individuals who are risk-averse or have shorter time horizons before they need their money.