Why Are Stock Funds Riskier Than Bond Funds

According to traditional investing knowledge, stock mutual funds are more riskier than bond funds. In this post, we’ll look at how stocks and bonds vary in terms of risk. We’ll also consider how much money we should put into stock funds vs bond funds.

Stock represents a portion of a company’s ownership. However, bonds are structured more like a loan to that company. If you examine a normal bond issuance and disregard the possibility that the issuing business may go bankrupt at some time, you will see that you know exactly how much money you will get back and when you will receive it. As an example, if you purchased a bond with a 6% yield, the dividend will most likely be paid as a 3% dividend every two years. If you keep that bond issue until it matures, you will be paid the face amount of the bond, say $100,000. The important thing to remember is that you would have to keep it for 20 or 30 years to get your money back.

However, as we all know, there is always the possibility that you may be unable to retain the bond until its ultimate maturity date. In such scenario, you may always sell it on the open bond market, but if interest rates have increased, you will get somewhat less than the face value of the bond. Of course, if you were lucky or astute enough to keep a bond when interest rates were falling, you might earn more than face value for your bond.

Another danger that many investors are not aware of is It is activated by a “callable” bond. In this scenario, the business issuing the bond has the authority to redeem, or call, the bond before it reaches its ultimate maturity date. If interest rates have dropped, a business may wish to call a bond and reissue it at the lower market interest rate.

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With that as context, we can see that stocks are riskier than bonds since bonds provide a reasonably predictable cash flow for the bondholder, while the company’s common stock has everything but a predictable cash flow. However, the other side of the coin is that a stock’s value has the potential to skyrocket. For example, if a stock gains 10% each year, it will be worth more than 8 times its initial value after 30 years.

One thing to keep in mind regarding bonds in individual investments. Individual bonds are not often held in most people’s investing portfolios. Bond mutual funds are more likely to be held by them. This is common in retirement portfolios such as IRAs and 401ks. Bond funds, on the other hand, operate very differently than individual bonds since they do not have a fixed maturity date. The disparity is so large that the common notion that stocks are riskier than bonds may no longer be valid.

All of this raises the issue of how much of your portfolio should be invested in stock funds versus bond funds…

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