Comparing Bond Volatility to Stock Volatility

On the whole, bond volatility is lower than stock volatility. This is particularly true because there is a large market of government issued bonds that are essentially free of risks associated with default. However, there are some key risks involved with purchasing bonds that do not make them free from potential losses.

Risks of Purchasing Stock

Purchasing a stock is, by definition, making a bet. An investor is betting the stock will go up in value based on market research. It is also possible to engage in short selling, which basically involves making the opposite bet. In either a traditional trade or a short sale, the investor thinks she knows what will happen with the future price of the stock. Even if she is making a safe bet, it is still a bet. The stock may perform the same way she thinks but to a smaller degree or to a larger degree. The stock may perform the opposite way than how she expects. There are high risk stocks and low risk stocks, but there is always risk involved because performance of the market is never definite.

Risks of Purchasing Bonds

Bonds do have a more definitive value. When a purchaser buys a bond, the purchaser is promised a given payout each year, called a coupon or interest. The purchaser is also promised the initial issuer will repay the bond at a given point in the future, called the bond's maturity. There is always the chance a bond issuer will go bankrupt and default on the bond, but there is a very low probability this will happen with most bonds. The biggest risk, then, is the bond will be offered at a lower price or a bigger coupon in the future. When either one of these things happens, the initial buyer will not be able to sell the bond immediately for a profit. The purchaser will lose money if he does so, and he may be disappointed he didn't purchase the bond at a later date. 

Evaluating Stock vs. Bond Options

When evaluating whether to purchase a stock or a bond, it is best to track each option over a given period of time with a mock investment. This will give an investor an idea of both the day-to-day volatility of a stock or bond as well as its long-term stability. Stocks are more likely to have large swings from day-to-day, and bonds are more likely to remain constant for weeks or months at a time. On the whole, however, an investor will likely see a higher upward trend on a stock that is performing well than on a bond that is performing well. There is no one answer to which option is best, which is why many investment professionals push diversity in a portfolio. By having stocks and bonds in a portfolio, an investor has a higher chance of large gains than with bonds alone. At the same time, the investor is more protected from losses than with stocks alone. Of course, a portfolio's performance depends more on which stocks and which bonds are held, but diversity is key in any portfolio.

blog comments powered by Disqus
Scottrade