Why Are Stock Funds Riskier Than Bond Funds

Posted by nick_niesen on November 8th, 2010

One bit of conventional investing wisdom is that stock mutual funds have much more risk than bond funds. In this article we take a look at how stocks and bonds will have differing risks. We will also look at how much we should invest in stock funds vs bond funds.

Stock represent a partial ownership in a business. But bonds are set up more like a loan to that business. Upon examining a typical bond issue, if you ignore the risk that the issuing company might go bankrupt at some point, you find that you know precisely how much money you will receive back and when you will receive it. Take this case as an example, if you bought a bond with a 6% yield on that bond, it will probably be paid as a 3% dividend every twice a year. If you hold that bond issue to its final maturity, you will receive the face value of the bond back, say $10000. The key thing to note is that you would have to hold it 20 or 30 years to receive all your money back.

But, as we all know, there is always some risk that you will not be able to hold the bond to its final maturity date. In that case, you can always sell it on the open bond market, but if prevailing interest rates have risen, you will receive somewhat less than face value of the bond in the open market. Of course, if you were fortunate or smart enough to hold a bond while interest rates go down, you could actually receive more than face value for your bond.

There is one other risk that many investors are unaware of. It comes into play with a "callable" bond. In this case, the company issuing the bond has the right to redeem, or call, that bond before its final maturity. A company may want to call a bond if interest rates had fallen, so they could then reissue the bond at the lower market interest rate.

With that as background, we can see that stocks are riskier than bonds because bonds will have a fairly certain cash flow for the bondholder, while the company's common stock will have anything but a certain cash flow. But the other side of that coin is that a stock has the potential to appreciate greatly in value. For example, if a stock were to appreciate 10% a year, in 30 years it will be worth more than 8 times its original value.

One key thing to note about bonds in individual portfolios. Most people don't hold individual bonds in their investment portfolio. They are more likely to have bond mutual funds. This is often the case in retirement portfolios like IRAs and 401ks. But bond funds behave quite a bit differently than individual bonds, since they don't have a final maturity. The difference is so great that the conventional wisdom that stocks are riskier than bonds may no longer be true.

So all this begs the question, how much of your portfolio should you invest in stock funds vs bond funds...

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