Choosing the right mix of stocks and bonds can be one of the most basic yet confusing decisions facing any investor. In general, the role of stocks is to provide long-term growth potential and the role of bonds is to provide an income stream. Typically, stock investors expect a fairly high rate of return because there is no schedule of repayment and no stated rate of return like that paid by fixed-income securities such as an investment in bonds.

In the stock world there are certainly variations in risk and reward. For instance, blue chip stocks are issues of companies that are well established within their respective industries and have long histories of producing earnings and paying dividends. On the other hand, small capitalization, or small cap stocks, represent shares in companies that are less established.

In the bond world, bonds represent loans made by investors to companies and other entities, such as branches of government, that have issued the bonds to attract capital without giving up managing control. Bonds are issued for specified time periods. Time to maturity and the issuer's ability to make good on its payment obligations are the two most important factors in choosing individual bonds to purchase. A rating indicating a high likelihood of repayment will allow an issuer to sell its bonds with a lower coupon rate than one that received a poorer rating.

Bonds, similar to common stocks, fluctuate in market value and, if sold prior to maturity, may produce a gain or a loss in principal value. U S government and U S government agency bonds are considered the safest bond investments. Corporate bonds are generally issued by industrial corporations, financial firms, public utilities, and transportation companies. They usually pay more interest than government bonds but carry a greater risk of default.

A key distinction when weighing the rewards of stocks versus bonds is that stocks have theoretically an unlimited ability for appreciation. It is true that a bond can sell at a premium prior to maturity, but the potential for appreciation is nowhere near as great as it is for stocks.

With stocks, although theoretically there may be no ceiling, there is a bottom. Stocks can drop in value and become worthless. When dealing with bonds, there is interest rate, inflation and credit risk. Credit risk is the risk that the bond issuer will be unable to make its payments on time or at all, effectively defaulting on the bonds.

Also, the higher the potential bond return, the higher the risk. When the bond expires and the principal original investment is returned, the bond is said to have matured. Which of these two investments is best for the individual depends on the level of risk they are comfortable with. Allocating investments between stocks versus bonds is one of the most important asset allocation decisions an investor can make.

When analyzing or comparing the stock market to the bond market the impact of current interest rates need to be considered. When the interest rate comes down, stock market and bond market typically move up; when interest rates move up, they both typically move down. On the other hand, stock prices tend to grow in time simply because the company tends to grow. As the economy grows, the firm that issued the stock tends to grow, and therefore the price of stocks is rising.

The relationship between the stock market and interest rates is one of the keys to understanding markets. Long-term investment success and wealth building is not picking the bottom. The path to long-term investment to success involves taking advantage of the opportunity to purchase an asset at an attractive valuation before the opportunity disappears. Keep these factors in mind when choosing to deploy funds between the stock and bond markets.

Happy Trading.


Jeff Neal 
Senior Writer, Options Strategist & Profit Strategies Radio Show Market Correspondent
Visit Jeff’s Forum