When new investors think about first taking control of their savings or retirement, one of the first questions they ask themselves is.. what do I invest in? A little bit of initial research will lead the new investor to discover that the most common types of investments outside of a savings account are bonds, mutual funds, and stocks.
In this comparative guide, I will provide a detailed comparison between all three investment mediums, including what they are, what the risks are, and what the typical return is like.
Before we jump into the comparisons, it is first important to understand the basis for each investment. Understanding why people, organizations, or governments are looking to fork over money with interest in the future in exchange for money today is extremely important to deciding which investment is right for you.
A bond is nothing more than a loan. A company or government may want money today to fund new projects, but does not have the money to fund the projects. The organization decides that they will issue bonds and pay the money back over time with interest. Bonds have a predetermined time duration and amount of interest that will be paid. As a result, there should be no surprise regarding the amount of money returned to you after the bond completes its term (a bond that has completed its term is said to have matured).
This makes sense for the company or government for a variety of reasons. If the government of a small town wants to build a new senior center, the annual budget for that town is not going to have enough extra revenue to build an expensive structure. A small town might only take in $2,000,000 in tax revenue for the entire year, so a senior center that costs $3,000,000 might be something the citizens and government want, but cannot quite fund. The town might be able to dedicate $200,000 a year to this project without affecting other programs.
In the town example, the city council might decide to issue $3,000,000 in bonds, paying a few percentage points of interest every year to bondholders. The city could get its $3,000,000 to start the project and then save its $200,000 a year over 20 years to pay back its bondholders.
The natural question becomes.. if a bond is nothing more than a loan, then why do bonds exist? Why would the government or company not just get a loan from the bank? The answer of course is to save money. Loans from banks carry higher interest than the typical bond. Bonds are among the lowest-yielding forms of investment, with typical quality bonds paying anywhere from 1.5% to 4%. The yield depends upon both the risk and the term – the longer you have to wait to get your money back and the higher the chance of not getting paid back, the better the yield.
As a whole, quality bonds have very low risk factor of not getting paid back. If the company or government issuing the bonds goes bankrupt, you could lose your initial investment. Bonds that yield over 4% typically belong to a risky company or government that may default, hence the higher promise of payout. Standard & Poor’s (and a few other organizations) will rate the credit of bond-issuing companies and organizations to help would-be investors understand risk. A bond issued by a company or government with an “AAA” rating from Standard & Poor’s means that the bond has an extremely low risk of not getting paid back. A rating of “AA” and “A” is still considered low risk, whereas anything in the “Bs” is moderately risky and anything in the “Cs” is considered very risky.
A Certificate of Deposit is just another type of bond. While a CD has a different name, these are practically the same thing as a bond except that a CD is issued by the bank. You give money to the bank for a pre-agreed upon amount of time and then the bank proceeds to lend it to would be homeowners, car owners, or business owners at a higher interest rate. They pay you a smaller interest rate than the interest rate they are charging for the loan. CDs tend to be a very poor investment when interest rates are low (like they are at the time of this writing) and even less appealing because the bank is making money directly off of your money – there are better options out there.
Mutual funds are theoretically diverse sets of holdings that allow investors to invest in a diversified position without the hassle of buying or capital requirement needed to buy into many different bonds or stocks. Mutual funds are typically themed – such as “bond funds”, “growth stocks”, or “20 year plans” (which assume the investor will start drawing off of the money invested in 20 years for retirement purposes).
While mutual funds sound great on paper, I am not a big fan of these funds. The main problem with mutual funds is that these funds are not a public service. Investors are typically charged an annual fee by the fund in order to pay the managers and for the company running the fund to take a profit. The problem with the amount charged is that it tends to be so high that it destroys the return. It is not uncommon for a mutual fund to charge a 1% (or more) annual management fee.
A lower-risk fund might only yield 4% a year, and charge a 1% fee on top of it. In such a fund, a $5,000 investment would be worth around $16,000 after 40 years. Without the fee, that investment would be worth over $23,000. The fund owners collected $7,000 worth of fees over the years on your $5,000 original investment!
Of course, there are some exceptions to the rule. Some bond-based funds can have an investment fee of just .15% – a much more reasonable sum. This can be useful for retirees or near-retirees who do not wish to take on the risk of investing in the stock market and want a diversified bond position (holding many different bonds reduces risk of losing money due to one of the bond-issuers defaulting).
Another fund subset that makes for a good investment is an index fund. Index funds will track a popular index, such as the S&P 500 (which follows roughly the top 500 companies trading in the US stock market). These funds tend to have low fees as well since there is no real managing to do (Vanguard’s S&P 500 index fund charges just a .17% management fee) – shares of each stock are bought and occasionally readjusted as stocks go up or down in value.
Most mutual funds that involve a manager picking individual stocks cost much more to manage and as a result are not worth the fee.
Stocks are a completely different animal from the bond. Unlike the bond where a company, organization, or governmental body is asking for a loan and offers interest, stock offers something entirely different. Rather than offering interest, companies that issue stock are offering ownership in exchange for money. Companies that issue public stock are giving anyone the opportunity to buy a piece of the company in exchange for cash.
Because ownership of stock just represents ownership of the company rather than a loan, there is no guarantee of return when buying stock. As a shareholder, you share in the ups and downs of the company. If business goes great, then the company’s shares will grow in value. The company may start paying a dividend (or raise an existing dividend) if earnings are strong. Dividends are a share of a company’s profits paid out to shareholders. Very mature companies often pay out 50%+ of earnings to shareholders in the form of a dividend.
Companies sell stock for two primary reasons: to raise money and to compensate the owners and early investors. The raise money portion is obvious: a company might need money to bring on more sales staff, research new product lines, or ramp up manufacturing capacity. Rather than get a loan, the company can sell a portion of itself to avoid taking on debt.
Companies also go public in order to compensate owners and individual investors. A huge corporation’s founder might be worth billions, but there is no way for that would-be billionaire to access that money without selling the company. The founder might not want to sell the company, yet still wants to access some of the wealth he (or she) has created. The founder could work to take the company public, selling 10% or the company in an IPO in order to have access to some of the wealth he has created without selling the entire company.
So Which is Better – Bonds, Mutual Funds, or Stocks?
So far we have discussed why companies, organizations, and governments sell bonds (to get a low-interest loan), mutual funds (to profit off management fees), and stocks (to raise capital and compensate founders/early investors), but we have not discussed why investors would want to hand over their hard-earned cash to the bond or stock issuers.
|Bonds||Stocks||Mutual Funds||S&P 500 Index|
|Yield||Low (1.5%-4%)||High (Varies)||Moderate (Varies)||9%-11% (Varies)|
|Risk||Very Low ("A" Grade or Higher)||High||Moderate||Moderate|
- Investors Invest in Bonds because they want a safe return. This makes sense if you need your money in the near future. The older you get, the more money you should have in the bond market. Historically, the market has needed about 5 years to recover from economic downturn, so if you plan on withdrawing all of your investment before then and need it for retirement, it makes sense to invest at least some of your savings into bonds.
- Investors Invest in Stocks because they want large returns. The S&P 500 has averaged nearly 11% over the last 30 years and 9% over the last 10 years (with dividends reinvested on both counts), whereas the bond market only is paying out 1.5%-4%. It makes little sense for anyone more than 10 years out from retirement to be heavily invested in anything other than stocks (or a low-cost S&P 500 index fund).
- Investors Invest in Mutual Funds largely due to ignorance. Many investors blindly put their money into mutual funds as that is what their human resources departments recommend, whereas stocks or even index funds would provide a larger return.
In short, if you have no risk tolerance and need your money in the near future for retirement, then you should be invested in bonds or a low-fee bond fund. If you have a long term for your investment and do not want to learn about stocks, invest into a low-fee index fund. If you have a long term for your investment and are willing to learn more about stock investing, investing in individual stocks is worth the time and effort.
Let’s take a look at how some of these investments might pay out over time. Imagine that you start with $5,000 to invest and can add an additional $1,000 per year. How will these different types of investments fare over 20 years? Over this term, a diversified bond holding would likely pay out around 2.75% (if you expanded the term to 30 years, the yield would go higher). Let’s imagine the mutual fund has historically averaged a 6% return with a 1% fee. The S&P 500 has averaged around 10% over the last 20 years (with dividends reinvested), whereas a moderately successful individual stock investor would yield 13% (just edging out market average).
|Bonds (2.5%)||Mutual Fund (6%)||S&P 500 Index (10%)||Stocks (13%)|
Of course, this table assumes a few things. Firstly, it assumes you have 20 years to invest. Secondly, the stock portion assumes you are a moderately successful investor. Beating the market average by a few percentage points is a solid feat. Some of the most famous investors of our day have averaged around 18% over their careers, so a 13% average return still requires some skill and research. With that said, investing in a low-cost S&P 500 index fund requires no skill, and handily beats the bond market, and if the term is long enough, just about every mutual fund in existence.
If you are interested in learning more about investing in stocks, be sure to read my stock-picking manifesto.