Like so many rivals—savory vs. sweet, Marriott vs. Starwood Hotels—when it comes to stocks vs. bonds, the real winner is a combo of both. Why? Because their differences actually complement each other very well.
When you invest in stocks, you're buying a share of a public company’s assets and earnings. The value of your shares goes up and down with the company’s financial well-being—or rather with investors’ perception of that company’s well-being. So they stand the chance to soar and give you great returns, or sink and bring losses.
Indeed between 1926 and 2013, the average annual return for stocks was 10.2 percent. But the worst year saw a 43.1 percent loss, while the best year offered a 54.2 percent gain, according to Vanguard data. Put simply: Stocks are risky, but potentially very rewarding over the long run.
When you invest in bonds, you're essentially giving a loan to an institution. And the corporation, government or other entity you're lending to is promising to pay you back—with interest—by a specified time. That means bonds are relatively safe as long as the entity stays in business. Over the same time period mentioned above, the average return for bonds was just 5.5 percent with a maximum annual gain of 32.6 percent and a maximum loss of 8.1 percent. Clearly, bonds offer lower risk, but also lower rewards.
Of course, some bonds are riskier than others because the likelihood of getting paid back varies. To gauge whether a borrower can honor its debt, check reports from ratings agencies that dole out grades ranging from “very likely” to “don’t count on it.” Moody’s rates the least risky bets as Aaa and the riskiest entities as C; Standard & Poor’s grades from AAA to D.
Similarly, the levels of risk and reward can vary greatly with stocks. For example, small companies tend to have greater potential for growth while large companies typically are more stable. Some high-risk “junk bonds” can actually be riskier than some high-quality stocks, which might even be able to supply some bond-like income with dividends.
Those nuances aside, though, the general thinking is that stocks equal aggressive investing and bonds skew more conservative. When you're determining what asset allocation is best for you, you want a blend of each of those, depending on your risk tolerance and time horizon.