In this article, we will compare the returns of stocks and bonds over time and discuss how to balance your portfolio by looking at returns relative to risks. We will also cover some tools and metrics that can be used to assess risks and returns and how to use asset allocation to achieve the best possible return based on your risk tolerance.
Are annual returns a good measure?
Annual returns are an important measure of performance, but they are not the only factor to consider when making investment decisions. How you invest depends on the timeframe you have before you need the money. If you are in the early or middle stages of your career and investing for retirement, your time frame is likely more than 10 years. On the other hand, if you are trading actively, you are looking for profits within days or weeks.
How much risk can you tolerate?
There are many more factors to consider in investment decisions beyond performance. What is your risk tolerance? For example, in 2020, market value dropped by 32% in just four weeks, reflecting the significant volatility in markets. If your time frame is short, or if the markets are unstable as we saw in 2020, you should take that into account when making investment decisions.
Measuring risk and return
There are two common ways to measure investment risk: beta coefficient and standard deviation. The beta coefficient measures the sensitivity of the investment to market movements, where a beta greater than 1.0 means the investment is more volatile than the market as a whole, while a beta less than 1.0 means the investment is less volatile than the market. Standard deviation measures the volatility of the investment, where lower standard deviation indicates a more stable return. A fund that invests in bonds is considered less volatile and less risky, providing a lower return compared to an equity fund.
How can asset allocation be used?
Asset allocation is the process of determining how much money to put into stocks, bonds, cash, and possibly other investments like real estate or commodities to achieve the best possible return based on your risk tolerance. Brokers and mutual fund companies can offer asset allocation models with pre-set allocations. These ready-made funds are an easy way for investors to create portfolios that align with their time frame and risk profiles.
Conclusion
By using tools like standard deviation, beta coefficient, and Sharpe ratio, along with considering ten-year returns, any investor can make smarter decisions about their portfolio and strive for the best possible return based on the risks they can tolerate. Ordinary investors often underperform the market, achieving lower profits in good years and suffering greater losses in bad years. But you don’t have to be like them. Be honest with yourself about how much risk you can take on, and don’t chase returns; unless you are an active trader, a long-term perspective is best.
There are many educational resources on personal investing available from regulatory bodies such as the federal government’s website (Investor.gov), the Financial Industry Regulatory Authority (FINRA), and the Securities and Exchange Commission (SEC), as well as the financial services industry. If you are new to investing or do not have time to do your own research, be prepared to work with a professional financial advisor.
Disclaimer: The Balance does not provide tax, investment, or financial services, and the information provided here does not take into account the investment goals, risk tolerance, or financial circumstances of any specific investor and may not be suitable for all investors. Past performance is not indicative of future results. Investing involves risks, including the risk of loss of principal.
Questions
Frequently Asked Questions (FAQs)
Do stocks or bonds achieve higher returns?
Bonds are generally considered less risky than stocks because the issuer usually returns the principal amount of the bond. Bondholders know what to expect from the return on their investments. The value of stocks depends on the company they relate to, which means their value can fluctuate quickly, leading to volatility. Overall, stock returns can be higher. If there is greater risk, there is the potential for higher returns.
How do bonds affect the stock market?
Bonds and stocks compete for investors. Bonds are safer than stocks but usually do not achieve high returns. Stocks, despite their extreme volatility, offer the opportunity for high returns. When stock prices fall, investors tend to invest their money in bonds. However, when stock prices rise, they become more attractive to investors and drive them away from bonds and back into stocks.
Source: https://www.thebalancemoney.com/stocks-vs-bonds-the-long-term-performance-data-416861
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