Investors must assess risks versus rewards when deciding which stocks and bonds to purchase. Stocks represent proportional company ownership, confer corporate voting rights, may pay you a portion of profits, and may be worth more or less than you paid for them. A bond is an IOU issued by a government or company in return for the loan of your money. The issuing authority pays you interest over the life of the bond and repay your principal at term’s end. Certain commonplace economic risks can affect returns on stocks and bonds.
Business Cycle Risk
The general state of the business cycle affects returns on both stocks and bonds, but in opposite ways. In times of business recession, when economic activity slows and negative shocks abound, the security of bond yields looks more attractive to investors and they move from stocks into bonds. Investors are driven away from stocks by the uncertainty about future stock dividend yields and earnings per share.
In periods of recovery and prosperity, when businesses generally are doing well, stocks look less risky and hold out the promise of higher yields than bonds, so investors tend to move from bonds into stocks. But sometimes a business reversal is so severe that you can lose money on both stocks and bonds, such as in the 2008 financial collapse. And mutual funds are no safeguard against a financial collapse. During periods of prosperity, managers of both stock and bond mutual funds tend to go for the riskier business sectors and investments because they promise higher yields. But when there’s an economic calamity, the riskier investments are the ones that turn sour first and fastest.
For bond investments, inflation is the biggest risk affecting returns. Bonds are long-term investments, with terms typically ranging from 10 to 30 years. They are fixed-income investments, meaning you get a fixed payment for each interest period. But inflation erodes the value of each interest payment. Inflation presents less of a risk for stocks because their price can rise with inflation. You can sell or redeem bonds prior to maturity, but you will forgo further interest payments and might not get all of your principal back. With bonds, there is also a risk that the issuer will default on interest payments. Bonds in default will be worth less than their face value and could become worthless.
Stock investors face three risks. There is a possibility that some business development will adversely affect an entire industry, dragging down all stocks in that industry. Nearly all businesses and industries face some sort of regulation. Stock investors also face the risk that some change in law or regulation will adversely affect the company or industry in which they have invested. They also face the risk that the individual companies whose stocks they own will make bad business decisions regarding products, management or strategies. The best defense against all types of stock and bond investment risks is to diversify, meaning you do not put all your money into just stocks, just bonds or the securities of just one company or industry.
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