The lower interest rates that are found on bonds, especially government-backed bonds, are often not seen as enough by investors. This is the main driving force behind certain investors not wanting to invest in bonds.
The Impact of Low Rates on Bond Investing
Many investors are more attracted to the potential double-digit returns that the stock market can produce, which are not seen as often in the debt market.
Despite the perception, the bond market can be very profitable for investors, as investing in bonds is considerably safer than investments in the equities market. It is often not until after an investment in the stock market goes wrong that investors realize how risky stocks can be. The underlying concept of this idea is the willingness of an investor to take on risk to reap a potentially greater reward.
This is one of the most basic tenets of the financial markets — the more risk you take on, the greater the compensation you need to receive. Investing in the stock market is considered to carry more risk than the bond market and, therefore, it generally provides greater returns for investors in the long run.
(To learn more, read Determining Risk and the Risk Pyramid.)
Risk vs. Return
It is the impact of these greater returns on a person's investments that affects the investment that person will choose. For example, imagine that you were able to invest in the bond market and earn five percent on your initial investment of $10,000 every year for 30 years. In this case, your investment would grow to $43,219. On the other hand, if you were to invest in the stock market, which provides a higher return of, say, 10 percent, that initial $10,000 would grow to $174,494 or just over four times as much (20 percent would get you $2.3 million).
The possibility of earning a significantly higher amount of money certainly influences investors to place their money in the stock market. It is important to note, however, that a 10 percent return on stocks is far from guaranteed and there remains a potential for loss. Nevertheless, it is the prospect of huge gains over time that draws some people away from the bond market and more towards the stock market.
(For more information, review Financial Concepts: The Risk/Return Tradeoff.)