Reasons Individual Stocks And Bonds Are Better Than Products
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Before mutual funds became the de facto standard investment option in 401 plans, before 401 plans became the de facto standard retirement savings option, most people invested in individual securities. Sure, mutual funds existed back then, but they often carried large commission charges, even larger front-end loads, and, to discourage you from leaving, mutual fund companies imposed large back-end fees.
Simply stated, mutual funds cost too much for the average investor. And by cost, the reference isnt to the funds underlying expense ratio, but to the actual out-of-pocket costs youd have to pay for the privilege of pooling your investment money with others.
For investors with small sums of money, mutual funds represented a fast way to secure professional management. They also provided an avenue towards greater diversification .
These days, almost everyone invests in mutual funds. With their omnipresence within 401 plans, its almost impossible to avoid them. Fewer people today are familiar with the benefits of building portfolios of individual securities. Instead, they rely on the one size fits all culture of financial products.
Heres the reality: one size does not fit all, especially for retirement.
Capital Gains Vs Fixed Income
Stocks and bonds generate cash in different ways, too.
To make money from stocks, youll need to sell the companys shares at a higher price than you paid for them to generate a profit or capital gain. Capital gains can be used as income or reinvested, but they will be taxed as long-term or short-term capital gains accordingly.
Bonds generate cash through regular interest payments. The distribution frequency can vary, but its generally as follows:
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Treasury bonds and notes: Every six months until maturity.
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Treasury bills: Only upon maturity.
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Corporate bonds: Semiannually, quarterly, monthly or at maturity.
» Learn more. Read about the different types of bonds, and how to buy them.
Bonds can also be sold on the market for a capital gain, though for many conservative investors, the predictable fixed income is whats most attractive about these instruments. Similarly, some types of stocks offer fixed income that more resembles debt than equity, but again, this usually isnt the source of stocks value.
Higher Quality Lower Risk
Within fixed income, opportunities look abundant, she says. But Norton is especially biased toward higher-quality, shorter-dated fixed income, which she says comes with the added benefit of lower risk, especially if a full-blown recession materializes.
One important bond market variable to watch are credit spreads. A credit spread is the difference in yield between two fixed income investments with the same maturity but different credit qualities. As the size of the credit spread represents the two investments differences in risk, widening credit spreads mean lower-quality securities get riskier and returns on those bonds lag higher-quality bonds.
If we start to see a recession, there could be a more meaningful widening of credit spreads.
However, the severity of the environment for credit-sensitive bonds is up for debate, Norton says.
On the one hand, defaults arent necessarily priced into the market now, because there hasnt been a large-scale corporate bankruptcy in so long. However, weve seen, as earnings come out, that companies are looking fundamentally healthy, so we may not see an uptick in defaults on a meaningful magnitude.
Still, Norton says investors can earn higher yields without taking on much credit risk.
In our minds, the better place to be within fixed income is higher-quality, shorter-dated fixed income, where youre not taking on as much risk.
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Upsides Of Stocks And Mutual Funds
Stocks offer capital appreciation to investors as share prices rise. Of course, the opposite is true when share prices fall. For example, consider investing in individual stocks. One of the companies you own shares in might experience a reputation-damaging scandal, thus sending the stocks price spiraling downwards.
Mutual fund owners normally dont experience the same kind of volatility. Fund performance generally stays relatively steady, safe but modest, at least compared to stocks. Since the mutual funds create instant diversity in your portfolio, you dont experience hits to the fund as hard as someone who owns stocks alone. Diversity is the key to protecting your investments from major losses because, like mutual funds, it allocates your money in multiple areas.
You can diversify a portfolio with only individual stocks. It would just take a lot of time and dedication to research since each choice must be made strategically.
Open An Account At A Brokerage
You can find many online brokerages, and its as easy as opening a bank account. You complete an application, provide proof of your identity, and then either mail a check or transfer funds electronically. Such accounts allow you to manage your own investments and have lower fees than a paid stockbroker who makes recommendations for you. On the other hand, this could be intimidating for beginners.
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A Comparison Of Returns On Bonds Vs Stocks
The below table compares the annual percentage change of the S& P 500 index and the annual return on the Bloomberg Barclays US Aggregate Index . The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, fixed-rate agency MBS, ABS, and CMBS .
| Year |
|---|
| 11.63 |
Buying Stocks Instead Of Bonds: Pros And Cons
Stocks and bonds each possess their own sets of advantages and disadvantages. Furthermore, each asset class features dramatically different structures, payouts, returns, and risks. Understanding the distinguishing factors that separate these two asset classes is key to building a healthy investment portfolio that thrives over the long haul.
Of course, asset allocation mixes are unique to each individual, based on an investor’s age, risk tolerance, and long-term investment and retirement goals.
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How Bonds Are Rated
Bonds are rated to help investors understand how risky they are. So before you buy a bond, it’s important to understand its rating and understand that ratings can change.
Bonds are rated on their credit quality by major rating systems like Standard & Poor’s and Moody’s. The ratings are based on the likelihood that the bond issuer will default, failing to pay its obligation to investors.
Here’s the basic rating system:
- AAA by Standard & Poor’s highest-quality bonds
- BBB or higher by S& P investment-grade bonds, for consideration by prudent investors
- Below this thresholdriskier but higher yielding bonds, often referred to as “junk bonds”
Not surprisingly, lower-quality bonds generally offer higher returns as an incentive to purchase in spite of the higher risk.
A Better Question To Ask
Rather than wondering if the market has bottomed, or trying to determine when it will happen, investors are better off revisiting their investing goals. That means asking yourself what your time horizon is and what you are investing for.
If you’re investing for a retirement that’s at least several years away, you’re better off ignoring the market volatility and continuing to invest at regular intervals. After all, if you are saving for retirement, you’re a net buyer of stocks, and you should remember that market pullbacks are actually good for net buyers of stocks as they make stocks cheaper.
If you’re hesitant to buy stocks in a downturn, it’s also worth remembering that missing out on the recovery could be a much bigger mistake than investing before the market bottoms.
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Stocks Vs Bonds: What You Need To Know
Even if you’re new to investing, chances are you’ve heard of stocks and bonds. Both are securities that can be bought and sold to net potential investment returns and grow your wealth, but they work very differently. When you buy shares of stock, you own a small piece of the company that issued it. With bonds, you’re loaning money to a company or group that promises to repay you with interest.
Both stocks and bonds have their place in a balanced investment portfolioand understanding how they work can help you make more informed investment decisions that support your long-term financial goals.
Blue Chip Vs Small Cap
Even within the world of stocks, there are variations in risk and reward. “Blue chip” stocks are issues of companies that are well established within their respective industries and have long histories of producing earnings and paying dividends.Small capitalization, or “small cap,” stocks represent shares in companies that are less established. Because of this, they have the potential for tremendous growth, which can translate into a large return for investors. Coupled with this, however, is a higher potential for decrease in their value than you would expect from well-established companies.
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How To Buy Bonds
You can either buy bonds directly from the federal government, which sells them at quarterly auctions, or you can buy them from a broker, the same way you would buy stocks. You can also buy them through an exchange-traded fund. An ETF is a collection of securities that track an underlying index. You can get started with a much smaller investment than with traditional bonds. ETFs dont mature, so itll be up to you to determine when you sell.
How To Choose The Right Asset Type For Your Portfolio
Determining which asset class to invest in and the right split between stocks and bonds will come down to a few different factors, including your:
Ideally, youll want your portfolio to be made up of a few different asset classes. Diversifying your asset mix with both stocks and bonds can help spread out some of the inherent risk that comes with investing.
A well-diversified portfolio reduces your overall risk by investing in a large variety of noncorrelated assets. By doing so, your investment performance will never kill it , but you will also never be killed , says Halleron.
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Special Considerations: Safety And Liquidity
CDs are the ultimate safe-haven investments because the money is insured up to $250,000. U.S. government bonds are also considered very safe. High-quality, highly rated corporate bonds are effectively safe from all but catastrophe.
However, remember that both come with a commitment to a length of time. You may not want to buy a long-term CD when interest rates are low or a long-term bond when interest rates are high. Assuming that the historical trend reverses, as it always does sooner or later, you may be locking yourself into a reduced rate of return.
Both CDs and bonds are relatively liquid investments, meaning that they can be converted back into cash fairly quickly. However, cashing them in before their redemption date can be costly. In the case of CDs, the bank may impose a penalty that eliminates most or all of the promised earnings and may even take a fraction of the principal. In the case of bonds, selling early at the wrong time risks the loss of value and the forgoing of future interest payments.
The wise investor keeps an emergency fund where money is available without penalty. That probably means a regular savings account.
Cons Of Buying Stocks Instead Of Bonds
In general, stocks are riskier than bonds, simply due to the fact that they offer no guaranteed returns to the investor, unlike bonds, which offer fairly reliable returns through coupon payments. Stocks are inherently more volatile than bonds because in the event of a corporate bankruptcy, bondholders have priority in being repaid. Meanwhile, owners of common stock are last in line, and can end up with nothing if the company goes bankrupt.
Risk-averse investors looking to safely deploy their capital and take comfort in more structured payout schedules would be better off investing in bonds.
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How To Choose The Best Investment For You
The best interest rate on some of the top high-yield savings accounts is about .60%, and the average interest rate on a bond is currently 1.06%, although the rate has been as high as 3.15%. Given that the average return on the S& P 500 is about 10%, why doesnt everyone just invest in the stock market?
When you invest in the stock market, the average rate of return is roughly 10%, but it fluctuates quite a bit. Consider this table on the rate of return for the past 20 years of the S& P 500:
| Year | |
|---|---|
| 2020 | 15.76% |
Some years, the S& P 500 gives you a great return on your investments. Look at 2003, 2009, 2013 and 2019. Double-digit return rates are certainly much better than what you would earn from bonds or savings accounts. However, the financial crisis of 2008 caused investors to lose a whopping 38.49%. Thats difficult to recover from, and it leaves some people leery about investing in the stock market at all.
Its also important to realize that these numbers reflect the stock market as a whole. If you invest in an individual company, your return could be much higher or lower.
Are Bonds A Better Bet Than Stocks Right Now
Morningstar Investment Managements Marta Norton lays out the changing calculus for investing across the markets.
Investors are feeling this new dynamic with big losses on both the bond and stock sides of portfolios, a turn of events not seen in the markets in recent decades.
Against this shifting backdrop, says Marta Norton, chief investment officer for the Americas at Morningstar Investment Management, theres a new key question for investors: Do better opportunities lay in stocks or bonds? Its a question Nortons own team is wrestling with as they weigh valuations and allocations across global markets.
Of course, the answer to that question starts with each investors financial goals and plan.
But for long-term investors in general, when it comes to stocks, even though valuations are more attractive than they were, its no longer the time to blindly buy the dip. Norton says the bear market can last a lot longer than many investors think. Her advice to investors is to move slowly and look for opportunities across asset classes.
At the same time, Norton says opportunities abound in fixed income.
When you look over the past 10 years, its really only been an equity story: Its been such a good market to take on equity risk, a tremendously good time to be an equity investor, Norton says. But today, its harder to know where to invest the marginal dollar. Fixed income is looking more appealing than it has in some time.
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Is It Better To Invest In Individual Stocks Or Stock Funds
Recall the original reason people wanted to invest in mutual funds. They desired both professional management and felt they could better diversify through mutual funds. This worked as long as mutual fund portfolio managers maintained small portfolios. As mutual funds became more popular through 401 plans, their assets grew, and so did the number of portfolio holdings. Today, its not unusual to see mutual funds with up to 1,000 securities or more.
That might be an example of over-diversification, which leads to the third advantage offered by building your own portfolio.
Reason #3: Its Easier to Diversify Using Individual Securities.
Investing directly in stocks and bonds allows retirees to diversify their portfolio and invest in a variety of securities, says Polanco. This can help mitigate risk and provide a level of protection against market downturns or economic recession.
Of course, when many ask if stocks are better than stock funds, what theyre really asking is:
Weighing The Risks And Rewards
Most certified financial planners and other industry leaders say that stocks and bonds each have very distinct roles in an investment portfolio. By weighing these varying risk and return levels, investors can choose just how much money they want invest. This is how you build an investment portfolio. In that case, determining the difference between stocks vs bonds which is better, isnt a simple one. In the end, the best thing to do is to use them both to complement one another.
Many analysts say that investors who are seeking higher returns should try and do so through investment in equities rather than purchasing risky fixed-income investments. The primary purpose of fixed incomes in an investment portfolio is the preservation of capital and diversification from stocks, not achieving the highest possible returns.
In Educounting, we love adages, and there are a lot of them used to help people determine the best way to allocate bonds vs. stocks in their investment portfolio. One such adage is the one that says the percentage of stock in ones portfolio should equal 100 minus their age. For example, if you are 30 years old, your investment portfolio would contain 70% stock and 30% bond or other kinds of safe investments. If you are 60 years old, the portfolio should feature 40% stocks and 60% bonds.
To help you decide, consider this fact:
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