Many people consider bonds to be stocks' more stable cousins, but in fact, bond investing also poses some disadvantages and risks. Managed wisely, bonds can be among the most valuable assets in your investment portfolio. They pay interest regularly, guarantee a fixed return and represent an alternative to the volatile stock market. If handled ineptly, however, bonds can wreck your financial future just as badly as plunging stocks.
How Stocks and Bonds Work
To buy a bond is to loan your money to the issuing corporation or the government. The bond routinely pays interest, and at maturity the bond issuer pays back the face value. When you buy stocks, you purchase shares of a company. If the company thrives, your stocks will grow in value and provide substantial returns. If the company tanks, you could lose it all. That is why many investors consider bonds to be safer. As stress-free as bond investing may sound, however, it also has some crucial disadvantages.
The term "inflation" refers to a general increase in prices of goods and services and a fall in the purchase power of money. Some bonds are inflation-protected, but many are not. Since bond interest payments are fixed, there is nothing you can do about the situation, except watch inflation erode the value of your bonds. For example, if your bonds pay 4 percent per year but inflation is running at 6 percent, you are basically losing money. Stocks, on the other hand, often stand a much better chance of outpacing inflation.
Bonds are not as liquid as stocks. Your money is "locked away" and won't be accessible until your bonds mature. True, you can trade your bonds before they reach maturity, but the market tends to be highly illiquid. As a result, you may have to sell them at a rate lower than your purchase price. Withdrawing the money early is another possible option, but it usually comes with penalties. For example, if you cash in savings bonds before five years pass, you will lose your three most recent months' interest.
Since the purchase of a bond is a low-risk investment, investors are willing to accept lower returns than they would get from stocks. Some may argue that even low-interest bonds can outperform bad stocks, which is true. On average, however, the return on a highly rated bond is still often much lower than the return on an excellent stock. Thus, while bonds may sound promising to investors who look for a safe and steady stream of income, stocks are a better choice for those who expect quicker and bigger growth in their investment.
- John Foxx/Stockbyte/Getty Images