Why stocks typically outperform bonds

Stocks provide greater return potential than bonds, but at a higher volatility along the way. Bonds are issued and sold as a “safe” alternative to the usually bumpy ride of the stock market. Promotions include over riskbut with the possibility of more come back.

More risk – more profit

As an example of stocks and bonds in the real world, bonds are essentially loans. Investors lend funds to companies or governments in exchange for bonds that guarantee fixed income and a promise to repay the original loan amount, known as mainat some point in the future.

Essentially, shares are partial ownership rights in a company that give the shareholder the right participate in the income that may arise and accumulate. A portion of these proceeds can be paid immediately in the form of dividendsand the rest of the income will remain. These retained earnings can be used to expand operations or build larger infrastructure, giving the company the ability to generate even greater future revenues.

Other retained earnings may be held for future use, such as repurchasing company shares or making strategic acquisitions of other companies. Regardless of use, if earnings continue to rise, the stock price usually rises as well.

Stocks have historically provided higher returns than bonds because there is a greater risk that if a company goes bankrupt, the entire shareholder’s investment will be lost (unlike bondholders who may recoup all or part of their loan principal). However, the share price will also rise despite this risk if the company performs well and may even work in favor of the investor. Stock investors will judge the amount they are willing to pay for a stock based on the perceived risk and expected return potential – profit potential due to expected profit growth.

Reasons for volatility

If a bond pays a known fixed amount rate of returnWhat causes its value to fluctuate? Volatility is influenced by several interrelated factors.

1. Inflation and the time value of money

The first factor is expected inflation. The lower or higher inflation expectations, the correspondingly lower or higher yield or yield bond buyers will demand. This is due to a concept known as time value of moneywhich revolves around the realization that a dollar in the future will buy less than a dollar today because its value decreases over time due to inflation. To determine the value of this future dollar in today’s terms, you need discount its value returns at some rate over time.

2. Discount rates and present value

Therefore, to calculate the present value of a particular bond, you must discount the bond’s future payments, both in the form of interest payments and repayment of principal. The higher the expected inflation, the higher discount rate which must be used, and therefore the lower current value.

Additionally, the further away from the payment the longer the discount rate is applied, resulting in a lower present value. Bond payments may be fixed and known, but the ever-changing interest rate environment exposes their payment streams to an ever-changing discount rate and therefore an ever-fluctuating present value. Since the initial stream of payments on a bond is fixed, a changing price of the bond will change its present value. effective yield. When the price of a bond falls, the effective yield rises; As bond prices rise, the effective yield falls.

Additional factors affecting bond prices

The discount rate used is not simply a function of inflation expectations. Any risk that the bond issuer may default (failure to pay interest or repay principal) will require an increase in the discount rate applied, which will affect the current value of the bond. Discount rates are subjective, meaning different investors will use different rates depending on their own inflation expectations and opinions about the creditworthiness of the bond issuer, which affect their personal risk assessments. The current value of a bond is the consensus of all these different calculations.

Bond returns are usually fixed and known, but what are stock returns? In its purest form, the corresponding stock return is known as free cash flowbut in practice the market tends to focus on reported earnings. These returns are unknown and variable. They may grow quickly or slowly, not grow at all, or even decrease or become negative.

TO calculate current valueyou must make your best guess as to what those future earnings will be. The situation is complicated by the fact that these incomes do not have a fixed expiration date. They can go on for decades and decades. To this ever-changing expected return flow, you apply an ever-changing discount rate. Stock prices are more volatile than bond prices because the calculation of present value involves two constantly changing factors: the income stream and the discount rate.