Investing: Risk Investments on Stocks and Bonds
As one of the most popular and accessible ways to invest, stocks and bonds allow you to reap the rewards of owning a part of a company or project and even allow you the highest interest savings accounts. However, as with any investment, people should understand the risks before buying them. Here are some things to keep in mind before buying stocks or bonds:
Bonds: Risk Investment
With the purchase of a bond, the creditor acquires the right to regular interest payments and the repayment of his capital after the end of the respective term. If the company encounters payment difficulties during this term, the bond creditor, in contrast to the shareholder, is given priority.
This preferential treatment is probably the greatest advantage of bonds over shares. Apart from that, of course, bonds also entail special risks. The preferential treatment of the bond creditor over the shareholder does not necessarily protect against a total loss. In addition to this issuer risk, bondholders must also accept inflation, interest rate, price, and currency risk.
Stocks: Risk Investment
In contrast to lenders, shareholders receive voting rights due to their direct participation in the company, which can be exercised at an annual general meeting. In addition, in the event of distribution, shareholders are entitled to a part of the profit paid out. In addition, in the event of a capital increase, shareholders are entitled to a subscription right, which enables the priority purchase of new shares.
Of course, the classic risks that affect bondholders also apply to shareholders. Due to the higher susceptibility to fluctuations or higher volatility, as well as the subordinate treatment in the event of insolvency, equities nevertheless carry a much higher risk than bonds. Because while the bondholder can be relatively indifferent to the business development of the issuer as long as it is still solvent, the shareholder has a very great interest in the respective company developing well economically. Because only an excellent business model paired with a positive economic development offers the long-term chance of rising share prices.
Read also: Difference Between Investing And Gambling
Diversified Investments: A Mix of Stocks and Bonds
“The only thing that is free when it comes to investing is diversification,” says Harry M. Markowitz, probably the best-known saying. For the purpose of portfolio optimization, the US economist developed the so-called capital market theory in the 1950s, which deals with the interaction between return and risk.
With the help of this theory, Markowitz was able to show that the risk of an asset class can be minimized if the investor positions himself diversified. “What is for free according to Markowitz is not the diversification itself, but the positive effect that investors buy with it. […] By diversifying their capital, investors can reduce their risk of loss on the one hand and increase their chances of return on the other,” says Die Assessment of the DWS fund manager Henning Potstada.
However, investors should not only position themselves broadly within one asset class but also diversify their assets across different assets. “The most important thing when it comes to diversification, however, is the correct distribution of assets across different asset classes, such as equities, bonds, currencies, and commodities,” the DWS manager continues.
Accordingly, it can be worthwhile for investors if they fill their securities portfolio with both bonds and shares. However, it is not possible to give a general answer as to which exact division between these two asset classes makes sense. “There is no general rule on how an investor should structure his portfolio with stocks and [bonds]. It depends on the person in question – their investment goals, their investment horizon, their risk tolerance, and their age,” says Potstada in a report by DWS.
The classic stock-bond rule of thumb is obsolete
The classic equity-bond rule of thumb “100 minus your age”, which is used to calculate the supposedly optimal equity ratio, is well known but is no longer up-to-date. The formula states that by the time a person turns 30, they should invest 70 percent of their investment capital in stocks and 30 percent in bonds.
However, with a current life expectancy in Switzerland of 81.4 years for men and 85.3 years for women, a 30-year-old person still has at least 51 or 55 years ahead of them, which makes a 30% bond share seem unnecessary. Because of the greater risk that an investor takes on over time with shares, he also receives a so-called share premium, which brings with it a significant difference in return. In addition, it is statistically verified that the world’s major stock indices, such as the S&P 500, have never made a loss within an investment period of around 10 years.
The yield differential between stocks and bonds
Investors who put $1 in long-term US Treasuries between 1925 and 2005 made a total of about $71 after 80 years, which equates to an annual nominal return of 5.5 percent. However, investors who put their US dollars into an S&P 500 ETF during this period would have been worth US$2,658 with an annual nominal return of 10.4%. Of course, there were no ETFs in 1925, but the enormous difference in returns shows what long-term opportunities the stock market offers compared to the bond market.
Due to this fact, investors should not shy away from a high share quota. In addition, the current phase of low-interest rates means that bonds with a good credit rating, even without taking the inflation rate into account, represent a predictable loss for creditors.