“Stocks” and “bonds”—these two words roll off the tongue of the average U.S. investor as if they were as interchangeable as your options for fruit at lunch.
But they’re not. They are more like “chickens and oranges.” And this mistaken identity, we would argue, is to blame for the misguided prominence of bonds in many people’s long-term investment portfolios, whether self-managed or assisted by an advisor.
“Stocks” and “bonds” are not just simple synonyms for “investments.” A stock is an ownership interest in a company. If the company endures in perpetuity, so does the stock. It’s like a chicken that continues to lay eggs, again and again and again.
A “bond,” in contrast, is a contract for a company to repay a loan according to certain fixed terms—including a fixed end date—so long as the company does not cease to exist. Because of this “expiration date,” a bond is much more like a piece of fruit—the “orange,” in this example—that will yield a certain limited amount of “juice.”
But why should you, the investor, bother with such technical distinctions? Why is it important to understand how different these investment categories really are?
The answer is that bonds are fundamentally much less helpful to the health and well-being of a long-term portfolio than stocks are.
And why is that? Two main reasons:
First: Although bonds may be fixed contracts, they do go up and down in value, sometimes substantially. That volatility is usually driven by changes in prevailing interest rates. Furthermore, because—like oranges—bonds have limited shelf-lives, they can lose value without recovering it before they expire (or mature). This interest-rate risk is often forgotten or glossed over. Yet in a low interest-rate environment, such as the one we’re in now, interest-rate risk is a serious concern, since bond values generally go down when interest rates rise.
To be sure, stocks—like chickens—are volatile creatures, too, more volatile than bonds. But that is no reason to ignore the volatility of bonds.
Second: Generally speaking, bonds are much less rewarding to own than stocks are. In the past 90 years or so, the average annual rate of return on medium-term corporate bonds has been about 6%. In that same period, the corresponding return on U.S. large-company stocks has been about 10%. With compounding, this difference becomes massive. If you adjust for the roughly 3% inflation rate during the same period, bonds tend to beat inflation by about 3%, stocks by about 7%. Here is perhaps an even more vivid comparison: Over twenty years, with those same growth and inflation rates, bonds have the potential to increase your purchasing power by about 80%, stocks by about 280%. (Admittedly, these examples don’t account for taxes or for fluctuations associated with specific twenty-year periods.)
So not only do stocks persist without expiring—thus having a greater opportunity to recover value that might be lost in a down cycle—but stocks also return much more. For the long-term investor, these are huge advantages in favor of stocks. Bonds are helpful, to some degree, for buffering volatility, or for short- and intermediate-term investment needs.
This is why Warren Buffett mostly avoids bonds and Michael Bloomberg’s personal investment advisor, Steven Rattner, counsels investors to consider “whether” to buy bonds at all.
We at Blair Hall Advisors happily join those two distinguished investors in our strong preference for equities in very long-term portfolios when there is little immediate need for proceeds.
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