Question

Why are stocks less risky than bonds in the long run?

Answer 1

Stocks provide greater return potential than bonds, but with greater volatility along the way. Bonds are issued and sold as a safe alternative to the generally bumpy ride of the stock market. Stock involve greater risk, but with the opportunity of greater return.

Bonds in the real world are considered akin to loans. 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 there is a greater risk that, if the company fails, all of the stockholders' investment will be lost. However, a stock's price will also rise in spite of this risk when the company performs well, and can even work in the investor's favor. 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.