When it comes to investing your money, two of the most common choices are stocks, which are also known as equities, and bonds, which are also known as fixed-income investments. One of the most common questions I hear from new investors is along the lines of "I don't want to take too much risk, but I also want to grow my money. Which is the better investment for me -- stocks or bonds?"
Here's a discussion of the pros and cons of each type of investment, and what the ideal choice is for the average new investor.
Pros and cons of stocks
You may have heard that stocks outperform every other major asset class over long periods, and that's true. Stocks are a smart choice for investors who want to maximize their long-term growth potential, as overall, stocks have produced annualized total returns of nearly 10% historically.
However, the downside is volatility. Stocks can be rather volatile investments and are therefore only appropriate for investment capital that you're not going to need anytime soon -- say for at least five years. To illustrate why this is important, consider that over the past 10 years, the S&P 500, perhaps the most representative index of the overall performance of stocks, has increased by 59%.
Here's the most important point. Notice that the path to that 59% gain wasn't straight up. In fact, by March 2009, the market had fallen by 55% from where it was on May 26, 2007, 10 years ago from this writing. Imagine if you had invested money in stocks in 2007 that you needed to pay your kids' college tuition with in 2009.
Also keep in mind that when I say "stocks," I'm referring to a well-diversified portfolio of 10 to 20 solid companies, or to stock-based mutual funds, not to individual equities.
Pros and cons of bonds
On the other hand, bonds, also known as fixed-income investments, are designed to produce steady income and protect your principal.
For example, a bond that costs $1,000 and has a 5% "coupon rate" would pay out $50 per year until maturity. At that point, your original $1,000 investment would be returned.
So the main reasons to invest in bonds include steady, predictable income, as well as capital preservation. The downside is that the long-term growth potential is significantly less than that of stocks. Over long periods of time, stocks have historically returned 9%-10% annually, depending on whom you ask, while bond returns are in the 4%-5% ballpark over the long run.
It's also important to mention that while bonds generally have less volatility and risk than stocks, they are by no means risk-free and can go down in value. Here's a primer on some of the risk factors all investors should know about bond investing.
The best bet: a combination of both
The answer to the question of which is better is both. However, the right amount of each depends of certain factors, particularly age.
Here's a quick but thorough guide to asset allocation. A general rule of thumb is that if you subtract your age from the number 110, you'll find the percentage of your investments that should be in stocks, with the remainder in bonds. For example, I'm 35, so that implies that 75% of my portfolio should be in stocks and the other 25% in bonds.
This isn't a one-size-fits-all rule, and your ideal asset allocation might be slightly higher or lower. The point I want to make is that nearly 100% of your investment portfolio should be invested in a combination of stocks and bonds, as opposed to being kept in cash-equivalent investments such as CDs or money market funds. And according to the rule, unless you're over 110 years old, you should always have some of your investment dollars in stocks.
Don't get me wrong -- it's a great idea to keep some cash on the sidelines in an emergency fund, or to convert a small percentage of your investments to cash if you're already retired and capital preservation is your top priority. I'm just saying that stocks and bonds should be the primary focus of your investment portfolio, regardless of your age.
The Foolish bottom line
The point is that a properly allocated investment strategy is the best way to go, and that either stocks or bonds is a better idea than simply sticking your money in a savings account. The average American doesn't own any either outside a 401(k) or other employer-sponsored retirement account, so it's fair to say that the average American would benefit from adding some stocks and bonds to his or her investment strategy.