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Stocks and Bonds: Pros and Cons

A dollar picked up in the road is more satisfaction to us than the 99 which we had to work for, and the money won at Faro or in the stock market snuggles into our hearts in the same way.

~ Mark Twain

I was going to do a single article on the pros and cons of investing in different asset classes right now, but I decided that there was too much information there, so I’m going to break it up into 3 articles which I’ll post this week. Today, we’ll take a look at the two asset classes you probably hear the most about: stocks and bonds.

The idea of this series is not to provide recommendations about which asset allocation is correct, but to provide you with some information you can use to make the determination that’s right for your situation based on the current state of the markets and the economy. If you are in your 20s, your choices will be different than those in their 40s or 50s. The amount of income you earn, your risk tolerance, your market knowledge and opinions will also affect your choices.

Stocks

Before I get into the pros and cons of putting your money in various types of stocks right now, let me just reiterate some facts about stocks in general:

  • Money in stocks is money at risk.
  • Stocks can go up or down by a little or a lot at any moment for any reason or for no apparent reason.
  • Stocks can trade sideways for long periods of time too.
  • No one knows for sure what stocks will do in any given time period.
  • History is a guide, but you can crash and burn if you’re always looking in the rear view mirror.

For a more general look at the pros and cons of investing in stocks in general, see Should You Invest in Stocks?

Dividend-Paying Stocks

We discussed this a bit in Friday’s post on No Respite in Diversification, but I’ll try to make the pros and cons clearer here:

Pros

  • Companies that pay dividends are usually larger, more successful enterprises that have been around for a while.
  • You can earn anywhere from a fraction of a percentage point to 6% or more from dividends, depending on the type of business.
  • Because they are usually relatively stable companies, these stocks sometimes fall less during bear markets.

Cons

  • As discussed on Friday, markets can sometimes become highly correlated (as they are now). During these types of bear markets, dividend stocks can get hit just as hard as all the others.
  • Companies sometimes cut their dividends. This can happen if an individual company encounters problems, or if we enter a vicious bear market and/or a very poor economy. If the dividend is cut, you will lose some or all of your dividend income and the share price will likely get clobbered to boot. (The clobbering usually happens before the dividend cut is announced, and the stock price sometimes recovers after the actual announcement.)
  • Companies with very high dividend yields should be avoided as that’s often a warning sign of pending trouble.

Other Types of Stock Allocations

I don’t have the space here to go into a great deal of detail on all of the different ways you can split your equity (stock) allocation, so I’ll just go through some of the basics and a few pros and cons for each:

  • Large Caps vs. Small Caps: Some investors like to diversify their stock holdings by market capitalization (ie. how big the company is). Large caps have the advantage of a proven track record and more stable stock price, but sometimes lack the growth boost that you can get from small cap stocks. You may find the next Apple in the small cap basket, but you’re more likely to go through a few companies that don’t pan out or even go bankrupt before you find that diamond in the rough.
  • Growth vs. Value: Some investors like to buy stock in companies experiencing very high growth rates, expecting the share price to increase quickly. The trouble with growth stocks is that, by the time everyone realizes they are growing quickly, that growth is already reflected in the share price. If you’re a little late to the party, you can get hurt. Other investors prefer to invest in stocks that they perceive as undervalued according to whatever metric they might use. The problem with this approach is that companies sometimes trade at low valuations for very good reasons. Perhaps growth is slowing, or they are encountering an operational problem.
  • Sector Allocations: Some investors like to diversify according to sectors like energy, utilities, consumer staples, consumer discretionary, etc.. This can be an effective way to spread risk, unless markets become very highly correlated. The key to this strategy is to remember that diversification within equities isn’t total diversification: you still need to hold other asset classes like bonds, cash, etc. to be truly diversified.
  • Geographic Allocations: Some investors believe they can achieve diversity by allocating capital to different regions like North America, Europe, or emerging markets. While it’s true that investing in fast-growing markets like the BRICs (Brazil, Russia, India, China) can add a little kick to your portfolio, you also need to be aware that they can fall quite precipitously as well. You may not like where you get kicked if that happens. 😉

These are just a few of the ways you can split up your equity allocation. But, as I mentioned on Friday, stocks are becoming more correlated lately, and it’s something to note if you’re looking to put money to work right now. Diversification within your equity allocation may be quite elusive until that correlation eases. You may want to lower your exposure to stocks for a while to reduce your overall risk.

Bonds

There are many ways to diversify within your bond allocation as well. Here are some general considerations in the current environment for bonds:

Pros

  • Currently, deflationary forces seem to be more prevalent, so there is still some room for bond prices to climb.
  • Bond prices tend to fluctuate less than stock prices.
  • Bonds provide interest income that is guaranteed, but only if the issuer doesn’t default and you hold the bond to maturity.
  • Even if bond prices are at or near a top, bond tops can last 2 – 14 years.
  • Inflation-protected bonds like Real Return Bonds in Canada, or TIPS in the U.S. can provide a good inflation hedge.
  • Although corporate bonds are often seen as more risky, some corporate balance sheets look a lot healthier than many sovereign balance sheets right now.

Cons

  • Bond prices have been rising steadily since the early 1980s, so the bull market may be getting a little long in the tooth. There may not be a whole lot left in the way of capital appreciation.
  • With very low yields, new bond purchases are not going to offer much income.
  • If inflation rears its head, bond prices may fall precipitously, causing significant capital losses.
  • The capital protection provided by buying individual bonds is at least partially lost if you buy a mutual fund or ETF.
  • Bond supply is huge right now, with sovereign and corporate entities vying for investors’ money. If bond traders start to demand more yield for their money, that would cause bond yields to rise and prices to fall. This idea of sovereign issuers crowding out banks and corporations that depend on the bond market to finance their operations has been a worry for quite some time. It hasn’t happened yet, as investors have become disenchanted with equities and can’t seem to get enough bonds. That may change at some point, and it could happen abruptly.

I’m sure I must have missed some of the pros or cons for stocks and bonds that are relevant in today’s market. Can you think of any others?

Comments

  1. Duke

    Excellent and accurate!

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