"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.

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 commence 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, once 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, once 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. Without the possibility of a greater return, no reason exists to take increased risk.

More Risk, More Return

Let's relate our example stocks and bonds in the real world. Bonds are essentially loans: Like your friend above, investors loan funds to companies or governments in exchange for a bond that guarantees a fixed return and a promise to repay 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 stockholder 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 expand operations or 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 of other companies. Regardless of the use, if the earnings continue to rise, the price of the stock will normally rise as well.

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, which 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.

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 the best guess as to what those future earnings will be. To make matters more difficult, these earnings do not have a fixed lifespan. 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.

The Bottom Line

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. More unknowns surround the performance of stocks, which increases their risk factor – and their volatility. They have the potential to generate greater returns than bonds, and over time have generally done so. But always remember that along with the potential for greater gain goes the potential for greater pain, too.