why bonds are better than stocks

5 Bond Funds that Beat the Stock Market

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Have you been hypnotized by the promise of stock investing? Three reasons why bonds are better than stocks.

Everyone loves to talk about stocks. On TV, on the internet, it’s all you hear about from investing experts.

Stocks are the get rich investment, that bet you’re making on a company that’s going to take you with it when it becomes the next Apple or Facebook.

But stocks aren’t necessarily the best investment or your only way to reach your financial goals. In fact, when adjusted for risk, bonds can beat the stock market and have a lot of other great benefits going for them.

Let’s start off with three reasons bonds are better than stocks before looking at some numbers than I think will make you a believer.

3 Reasons Bonds are Better than Stocks

First, bonds are a lot less risky compared to stocks. That’s just from what kind of investment they represent.

Stocks are a bet that a company will have profits in the future. Since everyone is betting on those profits, the cost of that bet in the stock price, can get really high. Just like any bet with everyone on one side, sometimes you’re taking a lot of risk and the payoff isn’t really that high.

For example, shares of Netflix sell for 196-times the profit the company has made over the last year versus a price of 16-times profits for shares of competitor 21st Century Fox. Of course, Netflix investors are betting that the online entertainment company will keep growing its profits by huge amounts but eventually that price multiple has to come down.

Growth is going to come down and new investors are only going to pay so many times for the bet on future profits.

This is to say nothing of the companies that might not even have profits in the future. So stock investors are taking a lot of risk on the chance that the company succeeds.

Bonds are investments in loans a company has taken. Not only do companies sell ownership through stock but they borrow money and pay a fixed-rate of interest. Getting a return on your bond investments doesn’t depend on the company’s success or profits. They have to pay you back.

All this means that the return on bonds is much smoother. You know how much return you will get for a bond when you buy it, if you hold it until the company pays off the loan completely. Even if you sell the bond early, the return doesn’t usually rise or fall that much.

Compare this with the return on stocks that can be up 20% in a year or down 50% – which we all know happens from time-to-time.

why bonds are better than stocksWhat good are higher long-term returns on stocks if investors freak out and panic-sell at the worst possible time? While stocks have provided about an 8% annual return over decades, the average investor earns around 4% according to research firm DALBAR because they don’t hold their investments long-term.

Another reason to invest in bonds over stocks is yield.

Cash is king and bonds give it to you. Companies pay off their loans with interest payments until the end of the bond and then they return a lump sum payment. Even in bond funds which hold thousands of individual bonds, the annual cash return can be more than twice that of stocks.

Finally, bonds are a stress-free investment. This has a lot to do with the volatility in stocks versus bonds but deserves a little time on its own.

Bonds are B-O-R-I-N-G!

If you hold them long-term, bonds provide a consistent cash return and a little bit of price return. It’s so consistent that you’re probably going to stop checking your investment portfolio every other day like you do with stocks.

You’ll just put your money in every month, let the account grow and enjoy your nest egg twenty years from now.

Bond Funds that Beat the Market

I pulled up the returns and data on my five favorite bond funds, each investing in a different segment of the market. The table below shows the annualized returns for the last three- and five-years as well as the management expense you pay and the dividend yield.

I also calculated the annualized volatility for each fund and for the stocks in the S&P 500. Volatility is just a measure of how much values rise or fall in a given year, how risky the investment can be.

proof bonds are better than stocks

Sure, stocks have offered a solid return of 7.4% over the last decade but at a much higher cost in grey hairs. Stocks can rise or fall by 10% on average in any give year and we all remember what happened in 2008.

Taking the ten-year return and dividing it by the volatility in each investment shows a completely different picture. On a risk-adjusted basis, all five bond funds beat the stock market.

Imagine giving up just a few percent of gain for almost no risk in your investments. Nice!

Why the Bonds Vs Stocks Question isn't so Easy

I’m not saying bonds beat stocks on every factor or that you shouldn’t have stocks in your portfolio. Everyone needs to own some stock investments for two very important reasons.

Absolute returns are higher for stocks. Higher risk means higher returns. If you can invest in a broad index fund like the S&P 500 so you don’t worry about individual companies, then you can take some of that stress out of stock investing.

Ben of Sure Dividend compares the returns of dividend stocks versus bonds using the rate on the three-year government bond instead of using volatility. This is a common measure to compare risk-adjusted returns called the Sharpe Ratio. Using this measure, select stock funds do beat bonds in some time periods (notably the 1-, 3- and 5-year) though bonds when out in the ten-year period including the recession.

Taking that stress out of investing is important because it will help you stay in your stocks and enjoy that long-term return. Remember, you don’t have to beat the market. Focus instead on beating your financial goals by holding all your investments long-term, no matter what happens to prices.

Stocks are also important for inflation protection. Bonds pay a fixed amount that doesn’t increase each year but inflation is eating away at what those dollars are worth. You’re getting the same $100 quarterly payment you got ten years ago but that $100 doesn’t buy as much.

Since companies can raise their prices along with inflation, the stock price generally rises as well because the company will be earning a slightly higher profit. Bonds are great for current income but you need stocks for that future income.

I still invest in stocks, even if it’s not as much as you’d expect given my age and how many years I have left to retirement. Bonds offer a lot of benefits that investors forget, or they get hypnotized by the promise of high returns and forget why they need bonds. Don’t invest exclusively in fixed-income but don’t neglect this great part of the market.

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