Bond and equity returns consist of capital gains and cash distributions. Bond returns consist mainly of periodic interest payments. Equity returns consist mainly of capital gains when you sell, although some companies pay cash dividends as well. The total return of your portfolio depends on your mix of stocks, bonds and other assets, as well as overall economic conditions.
Equities generally outperform bonds over the long term. The S&P 500, which is a broad market index of 500 large U.S. companies, has returned an average of 9.9 percent per year from 1926 to 2011, according to the Fidelity website. This is significantly above the 5.4 percent annual average return for intermediate-term government bonds. However, bond returns tend to be less volatile than equity returns. This relative stability makes government and other high-quality bonds a core component of conservative and balanced portfolios.
Bond returns depend on several factors, such as interest rates and the credit quality of bond issuers. Bond prices rise when interest rates fall because demand increases for older bonds with higher coupon rates. Prices rise until yields match prevailing market interest rates. Yield is the ratio of annual interest payments to market price, expressed as a percentage. Conversely, bond prices decline when interest rates rise, because demand falls for older bonds with lower coupons. The credit quality of bond issuers also affects bond yields, because investors demand higher returns for holding riskier assets. For example, Treasury bond yields are lower than corporate bond yields, because Treasuries are risk-free investments. Bond prices can also benefit from safe-haven buying, which occurs when investors move funds from stocks to high-quality bonds during volatile markets.
The factors influencing equity prices include overall economic conditions and the competitive environment. Rising interest rates slow down consumer and business spending, which hurts corporate profits and equity returns. Conversely, falling interest rates drive economic growth, which means higher profits and rising stock prices. The competitive environment determines a company's ability to gain market share, increase prices and drive profit margins. Smaller companies often have difficulty generating consistent returns because they must compete against larger companies with diversified global operations. However, small companies in certain industries, such as technology or health care, or in certain geographic markets, such as Southeast Asia and Latin America, can generate substantial returns because of high rates of sales growth.
The mix of stocks and bonds in your portfolio depends on your investment time horizon and tolerance for risk. You may prefer growth stocks and high-yield bonds if you are young and have started your first job, for example, because you want your portfolio to grow as quickly as possible. You can take on more risk because you have more time to recover from market downturns. However, if you are nearing retirement, government bonds and blue-chip stocks might dominate your portfolio, because you count on the regular income and safety of principal.
Based in Ottawa, Canada, Chirantan Basu has been writing since 1995. His work has appeared in various publications and he has performed financial editing at a Wall Street firm. Basu holds a Bachelor of Engineering from Memorial University of Newfoundland, a Master of Business Administration from the University of Ottawa and holds the Canadian Investment Manager designation from the Canadian Securities Institute.