Stocks provide greater return potential than bonds, but with greater volatility along the way. You have probably heard that statement so many times that you simply accept it as a given. But have you ever stopped to ask why? Why have stocks historically produced higher returns than bonds? Why are bonds typically less volatile? Understanding the reasons behind these trends could help you become a better investor. Read on to learn more. (For background reading, see Equity Premiums: Looking Back And Looking Ahead.)

Tutorial: Stock Basics

A Basic Example
Imagine that you are starting up a business. You are the sole owner and the only employee. It will take $2,000 to start operations and you only have $1,000, so you borrow the other $1,000 from a friend, promising to pay that friend $100 per year for the next 10 years, at which time you will repay the original $1,000 loan amount. The first year, after all expenses have been paid, including your own salary, you find that your business has earned $500. You pay your friend the $100 promised and keep the remaining $400. Your friend has earned 10% (100/1000) on his loan to you, but you have earned 40% (400/1,000) on your investment.

The next year does not go as well and after all expenses have been paid you find that the business has only earned $100. You pay that $100 to your friend, who has again experienced a 10% return. You on, the other hand, are left with a 0% return, although your two-year return is still around 20% per year. And so it goes.

With each year, you have the opportunity to earn more or less than the friend who loaned you funds. If the business becomes wildly successful, your return will be exponentially higher than your friend's; if things fall apart, you may lose everything. The loan is a contractual arrangement, so if you have to close up shop, whatever money may be left goes to your friend before it goes to you. As such, your position involves greater risk, but with the opportunity of greater return. If there was no possibility of greater return, there would be no reason for you to take the greater risk.

Expanding the Basic Example
Bonds are essentially loans, as in the example above. Investors loan funds to companies or governments in exchange for a bond that guarantees a fixed return and a promise of the return of the original loan amount, known as the principal, at some point in the future.

Stocks are, in essence, partial ownership rights in the company that entitle the shareholder to share in the earnings that may occur and accrue. Some of these earnings may be paid out immediately in the form of dividends, while the rest of the earnings will be retained. These retained earnings may be used to build a larger infrastructure, giving the company the ability to generate even greater future earnings. Other retained earnings may be held for future uses like buying back company stock or making strategic acquisitions. Regardless of the use, if the earnings continue to rise, the price of the stock will normally rise as well. (For related reading, see Knowing Your Rights As A Shareholder.)

Stocks have historically delivered higher returns than bonds because, as in the simplified example above, there is a greater risk that, if the company fails, all of the stockholders' investment will be lost. On the flip side, however, there is a return to stockholders that could potentially dwarf what they could earn investing in bonds. Stock investors will judge the amount they are willing to pay for a share of stock based on the perceived risk and the expected return potential – a return potential that is driven by earnings growth. Being predominantly rational as a group, they will calibrate their investments in a manner that properly compensates them for the excess risk they are taking.

The Causes of Volatility
If a bond pays a known, fixed rate of return, what causes it to fluctuate in value? Several interrelated factors influence volatility:

Inflation and the Time Value of Money
The first factor is expected inflation. The lower/higher the inflation expectation, the lower/higher the return or yield bond buyers will demand. This is because of a concept known as the time value of money. The time value of money revolves around the realization that a dollar in the future will buy less than a dollar today because its value is eroded over time by inflation. To determine the value of that future dollar in today's terms, you have to discount its value back over time at some rate. (For more insight, read Understanding The Time Value Of Money.)

Discount Rates and Present Value
To calculate the present value of a particular bond, therefore, you must discount the future payments from the bond, both in the form of interest payments and return of principal. The higher the expected inflation, the higher the discount rate that must be used and thus the lower the present value. In addition, the farther out the payment, the longer the discount rate is applied, resulting in a lower present value. Bond payments may be fixed and known, but the constantly changing interest-rate environment subjects their payment streams to a constantly changing discount rate and thus a constantly fluctuating present value. Because the original payment stream of the bond is fixed, the changing bond price will change its current effective yield. As the bond price falls, the effective yield rises; as the bond price rises, the effective yield falls.

The discount rate used is not just a function of inflation expectations. Any risk that the bond issuer may default (fail to make interest payments or return the principal) will call for an increase in the discount rate applied, which will impact the bond's current value. Discount rates are subjective, meaning different investors will be using different rates depending on their own inflation expectations and their own risk assessment. The present value of the bond is the consensus of all these different calculations.

The return from bonds is typically fixed and known, but what is the return from stocks? In its purest form, the relevant return from stocks is known as free cash flow, but in practice the market tends to focus on reported earnings. These earnings are unknown and variable. They may grow quickly or slowly, not at all, or even shrink or go negative. To calculate the present value, you have to make a best guess as to what those future earnings will be. To make matters more difficult, these earnings do not have a fixed life. They may continue for decades and decades. To this ever-changing expected return flow, you are applying an ever-changing discount rate. Stock prices are more volatile than bond prices because calculating the present value involves two constantly changing factors - the earnings stream and the discount rate. (To learn more, read Anything But Ordinary: Calculating The Present And Future Value Of Annuities.)

The Pricing Process Is (Usually) Rational
Hopefully you now have a better understanding of why stocks and bonds behave the way they do. This knowledge should place you in a better position to make more informed investment decisions. The pricing of all the thousands and thousands of stocks and bonds is essentially rational. Market participants apply their cumulative knowledge and best estimates as to future inflation, future risks and known or unknown income streams to arrive at present-day valuations. These valuations are constantly fluctuating based on continually changing expectations. In hindsight, one can see that emotions, even in the aggregate, can cause these expectations, and thus valuations, to be incorrect. For the most part, however, they are correct based on what is known at any given point in time.

Bonds will always be less volatile on average than stocks because more is known and certain about their income flow. Over time, stocks should generate greater returns than bonds because there are more unknowns. More unknowns imply greater potential risk. If stocks do not return more, then investors have become truly irrational and taken needless risk with their investment dollars.

Related Articles
  1. Mutual Funds & ETFs

    Top 3 Japanese Bond ETFs

    Learn about the top three exchange-traded funds (ETFs) that invest in sovereign and corporate bonds issued by developed countries, including Japan.
  2. Taxes

    Here's How to Deduct Your Stock Losses From Your Tax Bill

    Learn the proper procedure for deducting stock investing losses, and get some tips on how to strategically take losses to lower your income tax bill.
  3. Mutual Funds & ETFs

    What Exactly Are Arbitrage Mutual Funds?

    Learn about arbitrage funds and how this type of investment generates profits by taking advantage of price differentials between the cash and futures markets.
  4. Savings

    Become Your Own Financial Advisor

    If you have some financial know-how, you don’t have to hire someone to advise you on investments. This tutorial will help you set goals – and get started.
  5. Stock Analysis

    3 Solar Stocks to Add to Your Portfolio

    Understand the growth and challenges of the renewable energy market and its success in 2015. Learn about the top three energy stocks to add to a portfolio.
  6. Investing Basics

    What Does Plain Vanilla Mean?

    Plain vanilla is a term used in investing to describe the most basic types of financial instruments.
  7. Investing Basics

    What Does In Specie Mean?

    In specie describes the distribution of an asset in its physical form instead of cash.
  8. Economics

    Calculating Cross Elasticity of Demand

    Cross elasticity of demand measures the quantity demanded of one good in response to a change in price of another.
  9. Professionals

    How to Sell Mutual Funds to Your Clients

    Learn about the various talking points you should cover when discussing mutual funds with clients and how explaining their benefits can help you close the sale.
  10. Mutual Funds & ETFs

    Top Three Transportation ETFs

    These three transportation funds attract the majority of sector volume.
  1. What are the main kinds of annuities?

    There are two broad categories of annuity: fixed and variable. These categories refer to the manner in which the investment ... Read Full Answer >>
  2. What are the risks of rolling my 401(k) into an annuity?

    Though the appeal of having guaranteed income after retirement is undeniable, there are actually a number of risks to consider ... Read Full Answer >>
  3. How do I get out of my annuity and transfer to a new one?

    If you decide your current annuity is not for you, there is nothing stopping you from transferring your investment to a new ... Read Full Answer >>
  4. What are the risks of annuities in a recession?

    Annuities come in several forms, the two most common being fixed annuities and variable annuities. During a recession, variable ... Read Full Answer >>
  5. Are high yield bonds a good investment?

    Bonds are rated according to their risk of default by independent credit rating agencies such as Moody's, Standard & ... Read Full Answer >>
  6. Do mutual funds invest only in stocks?

    Mutual funds invest in stocks, but certain types also invest in government and corporate bonds. Stocks are subject to the ... Read Full Answer >>

You May Also Like

Hot Definitions
  1. Zero-Sum Game

    A situation in which one person’s gain is equivalent to another’s loss, so that the net change in wealth or benefit is zero. ...
  2. Capitalization Rate

    The rate of return on a real estate investment property based on the income that the property is expected to generate.
  3. Gross Profit

    A company's total revenue (equivalent to total sales) minus the cost of goods sold. Gross profit is the profit a company ...
  4. Revenue

    The amount of money that a company actually receives during a specific period, including discounts and deductions for returned ...
  5. Normal Profit

    An economic condition occurring when the difference between a firm’s total revenue and total cost is equal to zero.
  6. Operating Cost

    Expenses associated with the maintenance and administration of a business on a day-to-day basis.
Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!