Your Investment Approach: Stocks vs. Bonds
Stocks and bonds are investing terms most people understand to some degree.
But diving in a bit deeper and understanding exactly how they work is a great starting point to build your own investment approach.
I explained why building your own investment approach is so important in the first podcast episode of 2023 (listen here) and now we’re launching into a series that gets specific on how to do it. The goal is to move beyond dogmatic internet advice and empower you to build an investment approach that works for you.
The first part is all about understanding asset allocation: stocks and bonds. You can check out episode 64 of The Canadian Money Roadmap podcast to hear all about it, or read on here to understand key points.
Asset Allocation Fundamentals
Stocks and bonds are different assets that can make up your investment portfolio. And, how much of your money you put towards each of them is your asset allocation.
This is an important place to start when building your own investment approach because it helps you understand two things:
Return expectations
Portfolio performance in different market conditions
With this understanding, you can make the right investment approach that fits your goals. Even more importantly, you build a strategy that you’ll actually stick to.
What are Stocks?
I love the show “Dragon’s Den,” where entrepreneurs pitch their companies and ideas to a panel of investors. If they want to invest in the company, they often offer something like, “I’ll give you $100K for 10% equity in the company.”
Equity is ownership.
And stocks are often referred to as equity.
So, simply, stocks are ownership in a company.
By purchasing stocks, you are owning a small slice of a publicly-traded company. And, because of that ownership, you can participate in the profits of that company and build wealth. There are two key ways to do this:
Price appreciation: This means that the price of the stock goes up over time—it’s worth more. Eventually you sell it at a higher price you purchased it at, which earns you a profit.
Dividends: Some companies share a portion of their profits—a dividend—with their shareholders.
Stocks have been one of the biggest wealth-builders available and are very accessible today. Although we can’t rely on historical returns to predict future returns, we can say that investing in stocks is a great way to get your money working for you by capitalizing on the profits of other companies.
What are Bonds?
Bonds are, essentially, a loan.
Companies and governments can issue bonds to raise money to run their operations or the country.
Let’s say that the government of Canada, hypothetically, issues a 10-year bond for $1,000 at 2% interest. This means that you are loaning them $1K for 10 years; each year they pay you 20% interest, or $20, and at the end of a decade, they pay back the initial amount. Or, over 10 years, you earn $100 in interest from that bond.
The purpose of bonds in an investment portfolio is to smooth out the ride. An all-equity (all-stock) portfolio may be a wild investment ride, even if you achieve higher returns. In contrast, bonds are lower-risk assets that can absorb some of the impacts of stock fluctuations.
Understanding Risk and Return
I’ve already mentioned “risk” and “return,” but let’s get a bit deeper.
Risk and return are linked concepts, but they’re not the same thing. Many people state, “I’m a risky investor, I want to take on more risk.”
What they actually mean is that they want more return and they’re mistakenly assuming more risk automatically equals more return.
But the truth is that risk and return are not always linked. An optimal portfolio is one that provides the best returns with the least amount of risk. Risk is the chance you’ll have a negative or unexpected outcome—the more risk, the more chance of that happening.
And that’s why asset allocation is so important. It helps you find the right balance between risk and return in your portfolio based on a variety of factors.
Understanding Standard Deviation
To really understand risk and return, we need to look at standard deviation (apologies to those who aren’t so keen on math!).
In any given year, returns on your investment portfolio can be all over the place—positive, negative, high, or low. But, over time, it averages out to a certain number, say 10%. If you were to plot it out on a graph, it would look like a bell curve—there will be outliers on either side, but there will be the most instances of in and around the 10% returns on average.
Standard deviation, then, looks at the probability of possible outcomes so you can anticipate in advance what the expected range of outcomes could be for a given portfolio.
For reference:
One standard deviation from average provides 68% of outcomes
Two standard deviations provide 95% of outcomes
Three standard deviations provide 99% of outcomes
Now, let’s look at three portfolios here and some hypothetical numbers to illustrate how standard deviation works:
All-equity portfolio: 100% stocks
Here, the 3-year average returns on this portfolio are 7%. To get there, you had a standard deviation of 16%.
16% X two standard deviations = 32%
7% + 32% = 39%
7% - 32% = -26%
So, 95% of the time, you can expect your portfolio to provide returns anywhere between -26% to 39%. This is a very wide range of outcomes because of the high standard deviation.
2. Growth portfolio: 80% stocks, 20% bonds
The average returns over three years in this portfolio are 4.75% with a standard deviation of 13.7%.
Using the same math, 95% of all returns will be between -22.6% to 32%, which is a smaller range—the highs aren’t as high, but the lows aren’t as low.
3. Balanced portfolio: 60% stocks, 40% bonds
This last portfolio had average returns of 3% per year with a standard deviation of 11%, making the range of possible outcomes -20% to 26%.
As you can see, the more bonds in the mix, the lower the standard deviation and the lower the range of potential outcomes. This means you don’t have the potential for as high of returns, yes, but you are also reducing your risk for very low returns.
Again, these are bonds at work—smoothing out the ride of your portfolio so it doesn’t have such extreme highs and lows.
Risk Capacity and Risk Attitude
Some people may read through those previous examples and think, “Well, I have a high-risk tolerance so I’m ready for option #1!”
And while it’s true that some people are able to go “all in” with some investments, I’d caution you around the word “risk tolerance.” What it actually refers to is two unique concepts:
Risk capacity: Whether or not you have the financial means to take on risk, regardless of how you feel. Factors like being young, having no debt, or a lot of savings all increase your risk capacity.
Risk attitude: How you feel and react to risk. Some people are very anxious, worry all the time, and stress out when the market dips—this would be a low risk attitude.
You can see how these play together. Someone with a high risk attitude (isn’t scared of it) but a low risk capacity, cannot take on high-risk investments even if they wanted to—they don’t have the means.
Or, someone with a low-risk attitude might have the means for something riskier, but they’re going to be extremely anxious about it.
Understanding both of these elements helps you choose better asset allocations for your portfolio. If you have no idea about your risk tolerance, you can start with a simple questionnaire, like this one from Vanguard.
Be honest when you answer so you get a sense of what the right kind of strategy might be for you. If you try to be more “risk tolerant” than you actually are, you may end up with an investment strategy that’s not aligned at all with your goals and you give it up.
Okay, let’s put it all back together:
Stocks are ownership in a company and help build wealth.
Bonds are like loans to a government or company and help “smooth out” your portfolio.
The combination of the two in your portfolio is your asset allocation and will inform both the risk and return of your portfolio.
Understanding your risk capacity and risk attitude allows you to choose the best asset allocation for your investment strategy.
Understanding asset allocation is a key principle of your overall financial literacy and the first step to building your own investment approach.
Go ahead and listen to the full episode for more details and follow along in the series so you keep building up knowledge and insight to choose an investment approach that works for you.
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Evan Neufeld is a CERTIFIED FINANCIAL PLANNER® professional in Saskatoon, Saskatchewan and offers both investing and fee-only financial planning services.
*Disclaimer: Any numbers or rates of returns are used for illustration purposes only and should not be taken as fact. Note that the information in this article is current to the time of writing but is not guaranteed as up-to-date past then.
This article and accompanying podcast do not constitute personal financial advice. Evan Neufeld is a CERTIFIED FINANCIAL PLANNER professional in Saskatoon, Saskatchewan, and provides this Canadian personal finance content for educational purposes to the public. You are welcome to contact Evan to receive personalized fee-only financial planning or investment portfolio management.