Bonds vs Stocks vs Mutual Funds: What You Need to Know
Updated: Aug 18
Everyone knows you shouldn’t keep all your eggs in one basket. This is especially true when it comes to investing. But, its important to understand bonds vs. stocks vs. mutual funds if you want to preserve and grow wealth.
When you’re investing for retirement and other life goals, it’s important to have different types of investments to achieve the returns you need to reach your goals.
Bonds, stocks, and mutual funds are powerful components of a well diversified portfolio. That’s why it’s important to understand what these investments are and how they differ.
Bonds are investments designed to help governments or corporations raise money to finance projects. They can be viewed as a loan to investors. The investor does not receive stock ownership in the company, but they do receive an interest payment.
Example: Apple needs to raise $10 million to build more computers. They decide to offer a 5 year bond to investors to raise the money. You purchase the bond at the issue price and Apple pays you interest on the money paid for the bond. After the bond matures, Apple pays you back the value upon maturity, known as the face value.
Bonds are “fixed income” assets, which means they pay interest at regular intervals until they reach maturity. They’re called fixed income because the amount of the interest payments are fixed in advance. When you buy a bond, you’re basically making a loan to the issuer.
When you think of bonds vs stocks (we’ll explain mutual funds a bit later), bonds are usually considered the safest of the two assets. Bonds are safer because corporations are required by law to pay back bond investors before stock investors in the event of bankruptcy. But that doesn’t make bonds risk free.
Bonds are rated for credit quality by a credit rating agency such as Moody’s or Standard and Poor’s to help investors gauge their risk. Investment-grade bonds typically have a rating of A, AA, or AAA.
Eight bond terms to know
Types of bonds
Bond issuers can be cities and states (municipal bonds), the US Treasury (government bonds), or government-affiliated organizations such as the FHA or SBA (agency bonds). When governments and government agencies need to raise money to finance debt, they can only issue bonds, which is a unique characteristic of bonds vs stocks vs mutual funds.
Businesses also issue bonds (corporate bonds) instead of seeking a loan from a bank. Doing so is usually cheaper because the bond market has lower interest rates and better terms in many cases.
How much do you actually pay for bonds?
Most investors who buy stocks and mutual funds have a good idea of what they pay in commissions or expenses.
What you may not realize is that bond dealers also charge commissions (known as markups), but these costs are rolled into the quoted price for the bond. Companies such as Merrill Lynch, Wells Fargo, and Davenport & Company in Richmond, VA all charge markups to their clients. The problem is that most clients don’t know, and aren’t told, the true cost of their bond purchase in advance. This can make buying bonds as an individual much more costly than meets the eye.
Although new regulations require brokers to publish their bond markups, they don’t have to do so until after the sale. That makes it hard to know what you’re actually paying for bonds. Stocks and mutual funds are far more transparent.
Markups vary a lot, but Standard and Poor’s puts the average markup at about 1.2% for municipal bonds and 0.85% for corporate bonds. Some markups are as high as 5%! Given the relatively low yield of most investment-grade bonds in 2020, markups can have a huge impact on your overall returns.
For individual investors seeking bond exposure, we almost always recommend that clients purchase bond mutual funds or ETFs instead as a way to reduce cost and improve diversification. More on this later.
Where do bonds fit in your portfolio?
A great approach to investing for retirement is to aim for growth and income. The idea is to achieve growth with your stocks and income and stability with your bonds.
Bonds offer the potential to stabilize a diversified investment portfolio. The reason is that certain types of bonds can be very stable when stock markets decline. Your personal financial goals and preference for risk will dictate how much you may want to allocate toward bonds in your portfolio.
Unlike bonds, when you buy stock, you buy ownership in a company and in effect tie your financial future to theirs. If the business does well by selling more of their products and services, you may benefit by seeing the value of your stock increase; if it does poorly, you risk losing some or all of your investment.
Stocks tend to be riskier than bonds because you are not guaranteed that the stock will do well. But, you also have the opportunity to enjoy greater growth on your money.
Companies sell stock for a lot of reasons. They may want to expand into a new market, develop new products, or even pay off debt. The first time a company sells stock, it’s called an initial public offering or IPO.
Determining a “good” price for an individual stock is far from a precise science. That’s why you see wildly different analyst forecasts for the same stock. Picking individual stocks can be a risky business. If you choose a winner, however, the results can be amazing: A $10,000 investment in Google’s 2004 IPO would be worth over $300,000 today.
Unfortunately, the vast majority of investors fail to be “good stock pickers”. Substantial research has shown that even the brightest professional investors are unable to consistently identify winning stocks in advance. That’s why we often recommend that our clients purchase diversified mutual funds or index funds instead.
What does it mean to diversify your stock portfolio?
People often confuse asset allocation and diversification, but they are two different things.
Asset allocation can be defined as the right mix of stocks and bonds in your investment portfolio across different asset classes.
Asset classes can be described as more narrowly defined segments of stocks and bonds. For example stocks may be broken down further into U.S stocks, non U.S. stocks, small stocks, and large stocks. Bonds may be broken down into short-term maturity bonds, high credit quality bonds, non-U.S. bonds, and U.S. bonds.
The right mix of asset classes is your asset allocation.
Diversification is choosing different investments within each asset class to spread the risk and boost returns. Here’s why it’s important to diversify your portfolio:
Example: Charles is following the asset allocation strategy recommended by his financial advisor of 60% stocks and 40% bonds. From the outside, it looks like Charles is doing a good job balancing his risk. On closer inspection, however, Charles only owns 20 technology stocks. His biggest stock holdings include Google, Amazon, and Apple. His bond investments are from the same corporate issuers - Google, Amazon, and Apple! All of his investments are tied to the technology industry and he has too few holdings —his portfolio is not diversified.
It may be much better from a risk and return perspective for Charles to further diversify his investments so that many different industries are represented in his portfolio. Moreover, he should own considerably more stock and bond holdings.
While there is no guarantee, proper diversification may protect you against downturns in a particular sector or stock, and helps boost your returns with exposure to industries and markets with high growth potential.
Understanding mutual funds
In the bonds vs stocks vs mutual funds comparison, mutual funds sound the most complicated, but the concept is simple. In a mutual fund, investors pool their money to buy a collection or portfolio of assets. The money in the pool is managed by a fund manager who decides what assets to buy and sell based on the fund’s objectives.
Mutual funds may own stocks, but they’re not the same as stocks. When you buy shares in a mutual fund, you don’t actually own shares of the stock it invests in, you own a piece of the fund itself. A mutual fund share price is called the net asset value (NAV), and it’s calculated by dividing the total value of the assets in the fund’s portfolio by the number of outstanding shares.
Mutual funds aren’t traded on the stock exchange. When you place an order to buy or sell mutual fund shares, the order is filled after the market closes and the NAV is determined.
Different types of mutual funds
Mutual funds can invest in any asset class, so you can find bond funds, stock funds, money market funds, funds that invest in commodities such as precious metals or oil and gas, foreign exchange (forex) funds, real estate funds, and even cryptocurrency mutual funds. If you’re interested in exploring growth opportunities in markets with high barriers to entry, a mutual fund is a great way to get your feet wet.
Stock funds are one of the most common fund types. They are grouped according to what the investments are based on, such as:
Company size, i.e. large-cap or small-cap funds
Sector or industry such as health care or technology
Location—a single country (Japan, for example), a region (Europe) or global
Investing style such as growth funds, value funds, and blended funds
It’s possible to find a mutual fund for just about every investing style and objective.
What about index funds and ETFs?
An index fund is a type of mutual fund that tries to replicate the performance of an underlying stock index such as the Dow, the S&P 500, or London’s FTSE 100. Instead of hiring analysts to pick stocks for the fund, the fund manager simply buys the stocks on the index in roughly the same proportion as the underlying index.
Exchange traded funds or ETFs are a type of investment that is similar to a mutual fund, however there are some key differences.
For example, an ETF can also be indexed or it can be actively managed. Some invest in commodities; you can even buy ETFs backed by physical gold or silver bullion. ETFs trade on the exchange just like stocks, which means you can buy and sell them during the trading day. ETFs can be either passively or actively managed.
What is active vs passive management?
Mutual funds are either actively or passively managed. Index funds are passively managed; the fund manager’s job is to make sure the equities in the fund closely match the benchmark index. Passively managed funds aren’t out to “beat the market,” they simply want to generate the same returns as the underlying index. If the index declines, the fund manager doesn’t adjust the stock mix in an attempt to improve returns.
Actively managed funds aim to beat the market. These funds are usually pegged to an underlying index to measure performance.
For example, a fund’s objective might be to outperform the Russell 1000. Its management team relies on in-depth market research, analysis, and forecasting to pick stocks. Fund managers have to take more risk to generate higher returns, and there is more trading activity in these funds compared to index funds.
When you’re looking at bonds vs stocks vs mutual funds for your retirement investment strategy, passively managed funds have historically outperformed their active counterparts a majority of the time.
Standard and Poor’s produces a scorecard each year that shows how actively managed funds performed compared to their benchmark index. In 2019, 89% of all actively managed domestic mutual funds underperformed their benchmark over a 15-year period.
In other words, if you put your money in a low-cost index fund, 9 times out of 10, you’d have better results than someone investing in a high-priced actively managed fund.
Which is best: Bonds vs stocks vs mutual funds
There’s no single asset class that’s best for every investor. You should base your investments on four criteria:
Your age. Younger people have more time to recover if one of their investments doesn’t perform as expected. They can afford to be more aggressive in their stock and mutual fund choices.
Length of time until you need the money. If you are saving for college and your child graduates high school in three years, you need safer investments—think bond funds, CDs, and cash—than someone saving for college in 20 years.
Income generation. If you’re building a retirement portfolio, you want assets that generate income and preserve your nest egg. Bonds and dividend stocks are good options.
Risk tolerance/willingness to tolerate decline. This goes to the heart of who you are as an investor. If you’re the sort of person who panics over a 10% swing in the market, even knowing recovery is likely in a well-diversified portfolio, you won’t be comfortable with an investment plan heavily weighted toward stocks.
When it comes to risk in your portfolio, here’s my rule of thumb: Take your maximum tolerable 12-month decline and double it. That’s the percent of your portfolio you may consider investing in stocks and equity funds. The rest should be in safe assets such as bonds, bond funds, and money market funds.
Example: Bill and Catherine are approaching retirement. They both agree that they would be very uncomfortable if their nest egg lost 25% in a year. Bill and Catherine may want to limit their stock exposure to no more than 50% of their retirement portfolio.
Building your portfolio
It takes time and effort to build a well-diversified portfolio; there are over 10,000 stocks availble worldwide and 8,000 different mutual funds. It’s a huge task to compare them all and find the ones that align with your values, goals, and investment objectives.
Keeping expenses low is an essential part of building a portfolio that lets you retire with confidence. Management fees, transaction costs, tax liabilities all drag on performance. Even a 0.5% difference in returns has huge consequences over the long term.
Once you build your portfolio, it needs regular attention to make sure your investments are performing as expected and to replace those that no longer match your objectives. It needs to be rebalanced periodically to make sure your portfolio is in alignment with your asset allocation strategy.
At Covenant Wealth Advisors, we help you build a portfolio to help you achieve your investment goals. We take the time to get to know you as a person—find out what’s important to you—so your investments not only meet your financial needs, they align with your values.
We also offer expert advisory and management services to make sure your investments continue to work for you.
Covenant Wealth Advisors is an independent, fee-only advisory firm. We offer unbiased recommendations and transparent fees. If you’d like help building and growing your investments to help you reach your financial goals, get in touch for a free consultation.
Mark Fonville, CFP®
Mark has over 18 years of experience helping individuals and families invest and plan for retirement. He is a CERTIFIED FINANCIAL PLANNER™ and President of Covenant Wealth Advisors.
Disclosures: Covenant Wealth Advisors is a registered investment advisor. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital.The views and opinions expressed in this content are as of the date of the posting, are subject to change based on market and other conditions.
This content contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Please note that nothing in this content should be construed as an offer to sell or the solicitation of an offer to purchase an interest in any security or separate account.
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