Shares or bonds - which is a better investment?

Saturday, Feb 18 2012 by
5
Shares or bonds  which is a better investment

It's sure been a difficult time of late for stocks & shares. Over the last decade, the stock market has returned a feeble 0.6% vs. 3.9% for Gilts (and 1.6% for corporate bonds) and bonds have now matched or bettered stock returns over more than 30 years!

In light of this, there has been a lot of questioning recently about the relative attractiveness of shares versus bonds. Some suggest that investors should allocate entirely to bonds, not just because bonds are safer, but because they believe bonds will outperform shares over the long run. In other words, if bonds can deliver higher returns with less risk, what's the point of messing around with shares?

Citigroup wrote a piece in 2009 arguing that:

"The cult of equities was dead. Long live the cult of the bond".

Their theory: a half-century of bias of pension funds towards shares was reversing, and, given the lack lustre performance of shares, fund managers were instead turning to fixed-income investments for better returns. 

We're mindful of Blaise Pascal's trap that "People almost invariably arrive at their beliefs not on the basis of proof but on the basis of what they find attractive" but, before jumping on the bond band-wagon, we feel that it's worth being cautious for three reasons:

  1. Fundamental analysis supports the idea that shares should outperform
  2. The long run (and really long run) evidence still clearly indicates (by miles!) the superiority of shares versus bonds.
  3. There's grounds for believing that our recent experience with bonds has been highly unusual (even if it has lasted 30 years!)

What's the difference between shares and bonds?

The essential difference between shares (equity) and bonds is that investing in shares is about buying partial ownership in a company, as opposed to bonds which involve making a loan to it.  When an investor buys shares, the value will tend to reflect the earnings experience of the firm — good and bad. In contrast, bonds can never earn more than its face value (plus coupons). shares have (theoretically) an unlimited ability for appreciation but, at the same time, greater downside risk (because they are lower down the capital structure in the event of an bankruptcy). Their returns can be decomposed as:

i) Bond return  = Current yield + Capital gain 

ii) Stock return = Current yield  + Earnings growth +  Price Earning multiple change

Thinking about…

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Disclaimer:  

As per our Terms of Use, Stockopedia is a financial news & data site, discussion forum and content aggregator. Our site should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested.


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2 Comments on this Article show/hide all

vs777 29th Feb '12 1 of 2

hi stockopedia

I appreciate your thoughts, bonds are good when you dont want any kind of risk but fixed income is your desire and stocks are good for them who is liable to take risk in anyway. stocks can give you enormous return depends upon market condition.

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shade 13th Mar '12 2 of 2
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i) Bond return  = Current yield + Capital gain

I think some clarification is needed so readers won't confuse current yield and the "yield" as quoted on financial papers and sites. The yield quoted on the news (or just yield) involves the actuarial method of calculating return. In essence, it's the "average" return you would be getting per annum if you hold it to maturity, and this yield incorporates both interest AND capital returns.

Current yield is the ratio of the bond's coupon over its current price. It is a quick and dirty way of calculating return for that particular bond (or any cash/dividend paying asset for that matter) at its present price, but it should be noted that it's a "here-and-now" return and it's pretty inaccurate way of measuring return until maturity (which is the assumed fixed-income investor's investment horizon). 

I think a bond investor shouldn't (or would) be too concerned about how bond prices moves once an investment is made (unless selling them now yields a greater return than holding it to maturity, of course). I agree that they're very expensive at the moment. Vanilla bond yields are practically ZERO, and inflation-linked gilts are in the negatives! What I find odd about the bond market today is that buyers flock to bonds issued by countries with HUGE debt problems! I wouldn't lend my money to someone unless I'm confident he/she could pay me back. It makes no sense, to be honest.

As an additional note, I think it's worth comparing stocks with a steady track record of dividend payments and compare them to bonds. Companies which have a strong position in its industry and stellar historical performance like Tesco are paying dividends yielding at around 3%. Of course, past performance is by no means a predictor of the future, and careful research should be carried out before any decisions are made.

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