This idea, that bonds are a safer investment than stocks, is one that has been peddled for years to investors, but in fact it is very misleading.
First off, let's define the difference between stocks and bonds. Stocks are part ownership in a company. If you own a stock and the company's market value goes up, your wealth increases. If the market value goes down, your wealth decreases. If the company goes out of business, you lose everything.
Bonds are promises from a company (or government) to pay you back for money you have loaned it, plus interest. If interest rates drop, the values of bonds go up, and your wealth increases. If interest rates go up, the value of bonds drop, and your wealth decreases. If the company (or government) goes out of business, you lose everything. But if you hold a bond to maturity, as long as the company (or government) is solvent, you are guaranteed your money back plus interest. Even if the market value of the bond has dropped, if you don't sell it before maturity, you are guaranteed what the bond promised. This is one reason bonds are considered safer, and it is a legitimate reason.
Another reason bonds are considered safer is that their prices just don't move as fast or as much under normal circumstances. Stocks are the rabbit; bonds are the turtle. Sure, bonds will on average lose less money, but they will also gain less.
But here's the important point: If you plan on selling a bond before it matures, then other than its lower volatility a bond is really no safer or risk-free than a stock. The market prices of bonds can fluctuate quite a bit. This is particularly true in this age of economic crises and central bank interest rate manipulation. Below are charts of the stock market and five-year bond market for the last two years. Note that these bonds went down. They went down less than stocks went up, but the point is they lost money. This can happen at any time. So being invested in bonds does not guarantee protection from losses.
But, you say, I'll just hold my bond fund to maturity, that way I'll get all my money back plus interest. But that brings us to the most important point in this article. You cannot hold a bond FUND to maturity. Buying a bond fund is just like buying bonds that you must sell before maturity--its value is based on the market value of the fund's shares. So if you place your retirement money in a bond fund, and interest rates go up and stay up, you will lose money. The safety feature of holding a bond to maturity is not possible with a bond fund, and if you have a typical IRA, 401k or Keogh account, you are probably only invested in stock funds or bond funds. Few investors actually buy bonds directly, though it is possible to do so if you have a broker which offers them.
This is not to say that bonds are not a good investment, or that stocks are better. Both have their place. The point is that both involve definite risks.
Here's a recap:
- Stocks can go up in value.
- Stocks can go down in value.
- Stocks can become worthless.
- Bonds can go up in value (though are usually less volatile than stocks).
- Bonds can go down in value (though are usually less volatile than stocks).
- Bonds can become worthless.
- Bonds held to maturity guarantee money back plus interest (as long as the issuer is solvent).
- Bond FUNDS can go up in value.
- Bond funds can go down in value.
- Bonds funds can become worthless (though highly unlikely).
- Bonds funds DO NOT guarantee money back plus interest.
So if you are near retirement and your investment adviser suggests moving your money into a bond fund, ask him what the outlook is for the bond market. If he says it doesn't matter, fire him.
This article is for information only and is not intended as a recommendation to buy, sell or hold any financial instruments.
This article is for information only and is not intended as a recommendation to buy, sell or hold any financial instruments.
