Camille Van Vyve
04 May 2022
Stocks or bonds : how to find the perfect combination
Stocks and bonds are arguably the two best-known asset classes in the investment world. The best known… but not always the most mastered. Moreover, the recent announcements of rate hikes by the central bank are not without effect on the relative attractiveness of these two financial products. Once and for all, let's compare stocks and bonds to avoid confusion.
What is a share?
A share is a title of ownership corresponding to a fraction of the capital of a company. The latter can be listed on the stock exchange, but not necessarily.
How do you get paid as a shareholder?
A share is remunerated by a dividend, i.e. a share of the profits of the company allocated to each shareholder. The dividend is never guaranteed: not only can the company make losses in certain years, but also the beneficiary company can decide not to pay a dividend. On the proposal of the Board of Directors, it is during the annual shareholders meeting that will be decided whether or not to allocate dividends, their amount and the date of their payment.
Share value: the puzzle
The price of a stock is determined by the market, based on supply and demand. Depending on the information at his disposal, each investor will determine the value he deems correct for this share: if this estimated value is higher than the market price, it will be in his interest to buy it, if it is lower, to sell. From a strictly economic point of view, the value of a share corresponds to the discounted sum of the profits that the company is likely to generate in the future. The discounting of these future cash flows depends on parameters linked to the company's performance but also on parameters linked to the market, such as the economic, geopolitical, monetary context, etc. This makes the exercise arduous and explains the importance given to the work of analysts.
Holding period
Unlike a bond, there is no holding period associated with the purchase of a stock. It can be resold at any time.
Stocks and risk
There are actually several types of risks associated with owning stocks:
- Liquidity risk. It refers to whether or not the stock can be sold quickly on a regulated market. The number of buyers, the volume of securities in circulation and the capitalization will determine the liquidity of a share.
- Market risk. It comes from upward and downward fluctuations in the share price depending on the general economic situation, that of the sector or the health of the company itself. When it materializes, this risk leads to a capital loss for the investor when reselling the security.
- The risk of bankruptcy. It occurs especially when looking at small businesses. When it comes to publicly traded companies, this risk is almost non-existent.
- Currency risk. It exists for shares denominated in foreign currencies. For example, even if your US stocks go up in dollar value, if the dollar weakens against the euro, your profit could be reduced or wiped out.
Shareholder rights
In addition to the dividend, the share entitles the shareholder to several rights: the right to vote at general meetings of shareholders, the right to information or access to information communicated by the company, the right of distribution which gives the right to a part of the share capital in the event of liquidation of the company, and the subscription right which allows a shareholder to have priority in the subscription of new shares in the event of an increase in the share capital.
How to invest in stocks?
There are several ways to invest in stocks. You can invest in individual stocks or in stock funds, managed either actively or passively. The choice of a particular strategy will depend on your knowledge of the markets, the time you are willing to devote to your investments and your risk profile. Either way, passive funds or ETFs have the advantage of obtaining a diversified portfolio at a lower cost, since a single operation is necessary to gain exposure to a large number of listed companies and since the composition of the fund remains stable over time.
What is a bond?
A bond is a debt security corresponding to a fraction of the debt of a company or a State.
Interest rate and term fixed in advance
The bond offers a fixed interest rate over a fixed term, with the promise of repayment at maturity. The duration or term of the obligation can vary from less than one year to several decades.
Interest rate calculation
A bond is remunerated by interest, the rate of which is fixed in advance. This rate is calculated according to the policy rate set periodically by the Central Bank, at which it remunerates the deposits of banks placed with it. Depending on the economic and financial situation of the issuer of the bond and its presumed ability to repay, additional interest is added to the policy rate to compensate the investor for the risk incurred. This increase is called “risk premium”. Typically, government bonds carry lower interest rates than bonds issued by private companies because they offer greater repayment guarantees.
Price/rate correlation
The price of a fixed rate bond moves inversely to interest rates. When they increase, investors' return expectations also increase: as a result, an existing bond with a lower rate than the market will suffer a fall in price, in order to align its total return with investors' expectations. Conversely, if interest rates fall, bond values rise.
The bond, a risk-free asset?
Although the bond is often described as a “risk-free” asset, its holder nevertheless incurs two main types of risk:
- Market risk. If a bond is resold before its maturity in an unfavorable rate environment, the investor may lose part of his investment.
- The risk of bankruptcy. If the borrower is unable to repay, the bondholder may lose some or all of their investment.
The bond remains, however, in general, much less risky than stocks. On the one hand, because the value of a bond remains more stable and reacts to a lesser extent to changes in the economic situation of a company or a state. On the other hand, because the holder of a bond has priority and is reimbursed before the shareholder in the event of bankruptcy.
How to invest in bonds?
As with stocks, the investor can choose to buy individual bonds or invest in bond funds. There are also passive bond funds, which replicate the performance of a basket of bonds, such as euro zone government bonds.
Build a balanced portfolio
Historically, bonds were intended to protect the purchasing power of bondholders against inflation. Today, they mainly allow investors to diversify their assets and partially immunize themselves against a decline in the equity market. The proportion of bonds you should hold in your portfolio will depend on your investment objectives and your risk aversion. The shorter your horizon, the higher the share of bonds should be. Similarly, the higher your risk aversion, the more bonds you will need to hold to reduce fluctuations in your portfolio.
Bonds and interest rate environment
In an environment of rising interest rates, bondholders see the value of their portfolio decline in the short term; reselling before maturity would incur a loss. But this decline will normally be offset by a rise in yield over the longer term. For those who had waited before investing, bonds become more attractive when interest rates rise; this kind of context is ideal to start investing. To precisely determine the share of bonds you should hold, we invite you to do your own simulation below.