Stocks Vs. Bonds Investment Strategy: Which Asset To Choose (Returns, Performance, Risk Analysis)

For many, owning a business or buying expensive real estate is out of the question. An alternative to growing your net worth over time is to invest in financial instruments such as stocks and bonds. In this article, we look at the stock vs. bond investment strategy.

Various investment strategies use stocks and bonds in their portfolios, but the two types of securities are entirely different, with their distinct advantages and disadvantages.

By mixing stocks and bonds together, you can get high returns in the markets when the markets are moving up and also limit losses when the markets are moving down (at least, that is what history tells us).

Related reading: – Investment strategies library

Let’s look at the stocks vs. bonds investment strategy:

What are stocks?

First, let’s explain what a share is:

When you buy a share, you essentially buy a stake in a company. Over time, stock prices can increase as a company’s earnings and shareholders’ equity increase. Historically, stocks have been the best-performing asset class.

• Best stock markets of the world

For example, if a certain company’s stock price is $10 per share and you buy 100 shares, you have invested $1,000 in that company. In 10 years, if the price of that stock rises to $100 per share, your original 100 shares are worth $10,000. Your profit will be $9,000 or 900% of your initial investment.

While stocks can make a profit over time, you also run the risk of losing capital if the company’s performance declines. For example, if the same company’s share price falls to $4 per share during those 10 years, you will lose $600, or 60% of your initial investment. You pay this price for assuming the risk of investing in stocks. As a matter of fact, most stocks tend to perform poorly over their lifetime. Thus, it’s paramount you diversify.

Many companies also share a portion of their earnings (or retained earnings) with shareholders by paying dividends to the shareholder. Dividends are not guaranteed and may change over time, but once received, they increase your income. A company can also buy back shares and thus you increase your ownership in the company.

• Are Buybacks Good For Stocks And Investors? Buybacks And Stock Returns
• Can dividends make you rich?

To reduce risk, it is generally recommended to diversify your stock portfolio by investing in more than one company, industry, and stock type.

Types of stocks

There are many types of stocks, including:

• Value Stocks: stocks of companies with good earnings that sell for less than their intrinsic value;
• Growth Stocks: often in new or growing industries where profits can grow faster than the industry or market average;
• Dividend Stocks: These typically pay consistent dividends, but have not historically had strong stock price appreciation. The category was once dominated by energy, financial services, and utilities, but now more tech companies are paying and increasing dividends;
• Blue Chip Stocks: These are stocks of large and reputable companies with a long growth history. They also often pay dividends.

• Value vs. growth investing

Advantages (pros) of stocks

• High Historical Returns. Historically, stocks have generated an average annual return of 10%, although this varies yearly, and results differ between companies and industries. In the long run, stocks can provide you with a greater return on investment than securities such as bonds. But it assume you have a diversified portfolio;
• High Growth Potential. While no one can accurately predict how the markets will behave when you invest in stocks, you can invest in a growing industry or company and make a profit over time;
• High Liquidity. Ordinary stocks of large corporations are considered liquid investments. You can sell these investments quickly and easily as your financial goals change over time.

Disadvantages (cons) of stocks

Unfortunately, it’s not all rosy when you invest in stocks: there is a real risk of losing your capital, especially if your time horizon is short. While stocks have produced good results over the long run, you might lose money even over ten-year periods. For example, from the dot-com bubble in 2000 until 2011, S&P 500 had negative absolute returns! And not to mention the period after the crash of 1929.

Here are the disadvantages and cons of investing in stocks:

• Economical risk. Any poor state of the economy can prevent a corporation from achieving the desired profit levels. The quality of the economy is affected by recessions, inflation, unemployment, or fluctuations in interest rates;
• Political or social risk. An objection to the nature of the activities of a particular company or to the way it conducts its business;
• Promotional risk. Bad advertising of a company’s products and services can lead to lower prices and profits;
• Falling demand risk. Changing behavior and preferences of consumers can lead to lower prices and profits;
• Political or global risk. Changes in exchange rates or diplomatic relations can lead to lower prices and profits;
• Management risk. Competitive actions or poor management decisions can lead to reduced profitability or business losses.

Stock investment strategy – backtest, returns, performance

Let’s backtest the stock market’s historical performance under the following conditions:

• Passive asset allocation strategy with annual rebalancing;
• The backtesting interval from 2007 to 2023;
• Historical quotes are adjusted for dividends;
• Stock index ETFs instead of individual stocks are picked.

For stocks, we have picked these ETFs, which are well diversified, have high liquidity, and a long performance history:

Stock Class Type	ETF Name	ETF Ticker	Weight
Large Cap Blend Stocks	SPDR S&P 500 ETF Trust	SPY	20%
Small Cap Blend Stocks	iShares Core S&P Small-Cap ETF	IJR	20%
Large Cap Value Stocks	Vanguard Value Index Fund	VTV	20%
Small Cap Value Stocks	iShares Russell 2000 Value ETF	IWN	20%
International Stocks	iShares MSCI EAFE ETF	EFA	20%

Portfolio equity curve:

Portfolio underwater curve (drawdowns):

The portfolio’s monthly and annual returns:

Year	Jan	Feb	Mar	Apr	May	Jun	Jul	Aug	Sep	Oct	Nov	Dec	Yr%
2007	1.4%	-1.1%	1.8%	3.1%	3.5%	-1.6%	-4.7%	1.1%	3.0%	1.7%	-5.3%	-1.6%	0.8%
2008	-5.6%	-2.6%	-0.2%	4.6%	1.9%	-8.7%	0.5%	1.8%	-7.3%	-18.9%	-8.8%	4.2%	-34.8%
2009	-11.7%	-12.1%	8.1%	13.1%	6.0%	-0.2%	9.3%	4.2%	4.1%	-3.8%	4.3%	3.8%	23.9%
2010	-3.4%	2.9%	7.0%	2.7%	-8.4%	-5.8%	7.6%	-5.6%	9.7%	3.7%	0.3%	7.8%	17.8%
2011	1.5%	4.1%	0.4%	3.1%	-1.4%	-1.9%	-2.8%	-7.4%	-9.1%	12.0%	-0.5%	0.9%	-2.8%
2012	5.3%	3.3%	2.5%	-1.3%	-7.1%	5.0%	0.1%	2.9%	2.8%	-1.0%	0.9%	2.9%	16.8%
2013	5.4%	0.7%	3.5%	1.8%	1.9%	-1.1%	5.9%	-3.1%	5.0%	3.9%	3.0%	2.0%	32.5%
2014	-4.0%	4.7%	1.0%	-0.4%	1.2%	2.8%	-3.3%	3.2%	-3.6%	3.5%	1.0%	0.3%	6.1%
2015	-2.8%	5.6%	-0.2%	0.3%	1.0%	-1.2%	0.3%	-5.9%	-3.3%	6.9%	1.1%	-3.1%	-2.1%
2016	-5.6%	-0.3%	7.3%	1.5%	1.2%	0.1%	4.2%	1.1%	0.4%	-2.6%	6.9%	3.1%	17.8%
2017	0.8%	2.3%	0.3%	1.0%	0.1%	1.7%	1.6%	-1.0%	4.3%	1.4%	2.7%	0.6%	16.9%
2018	3.8%	-4.3%	-0.6%	1.1%	2.7%	0.2%	3.2%	2.1%	-0.8%	-7.9%	1.8%	-9.6%	-9.1%
2019	8.6%	3.4%	-0.6%	3.6%	-6.9%	6.7%	0.4%	-3.3%	3.4%	2.4%	2.7%	3.0%	24.8%
2020	-2.9%	-8.9%	-17.7%	10.8%	4.1%	2.1%	3.7%	5.1%	-3.4%	-0.5%	14.8%	5.6%	8.8%
2021	1.7%	5.5%	4.6%	3.0%	2.5%	-0.1%	-0.4%	2.2%	-3.2%	4.6%	-2.8%	4.9%	24.3%
2022	-4.6%	-1.0%	2.0%	-7.2%	1.7%	-8.6%	7.7%	-4.0%	-9.3%	10.2%	6.2%	-4.8%	-13.1%
2023	7.4%	-2.5%	-1.3%	0.2%	-0.9%	N/A	N/A	N/A	N/A	N/A	N/A	N/A	2.7%

The portfolio’s performance statistics compared to the benchmark S&P 500 Total Return index:

Statistical Metric	Portfolio	S&P 500 TR
Annual Return %	6.55%	8.95%
Exposure %	99.98%	100.00%
Risk-Adjusted Return %	6.55%	8.95%
Max. drawdown	-58.39%	-55.19%
CAR/MaxDD	0.11	0.16
Standard Deviation	24.43%	22.64%
Sharpe Ratio (3% risk-free)	0.15	0.26

What are bonds?

When you buy bonds, you are lending money to the issuer of the bonds, which is usually a company or government agency. Unlike stocks, you don’t get equity in a company by investing in bonds. You’re a lender, not an owner. Bonds have a maturity date when the loan is due in full, and they usually offer fixed interest payments.

As a general rule, bonds with longer maturities offer higher interest rates as investors take on more risk. Similarly, higher-quality bonds usually offer lower interest rates because investors’ risk is usually lower. Bonds also have different levels of liquidity.

Bonds are less risky than stocks because, in the case of bankruptcy, the bondholders are paid before shareholders.

Types of bonds

Some of the more common types of investment bonds available to investors are:

• Corporate bonds: These are issued by private corporations. The debt can be repaid by the company and repaid by a fixed date, returning you the principal amount of the debt and accrued interest. Or, in the case of callable bonds, the corporation can “call” or buy back the bond, allowing them to redeem its bonds before the maturity date. Corporate bonds are usually classified as investment grade or high-yield bonds:
  • High-yield corporate bonds: Usually pay higher interest rates because they have a lower credit rating than investment-grade bonds. High-yield bonds are more likely to fail, so they must pay higher yields than investment-grade bonds to offset investors’ risk;
  • Investment-grade corporate bonds: usually offer lower yields because they have lower interest rates and a higher credit rating.
• Government bonds: Government bonds backed by the US government, such as US Treasury bonds, are generally considered a lower-risk investment option. Although the terms can vary from a few days to several years, the government guarantees the lender timely payment with interest. Interest earned is subject to federal income tax;
• Municipal bonds: Municipal bonds are issued by states, counties, or municipalities. They are generally exempt from federal income tax and may also be exempt from state income tax under certain conditions. While these bonds generally offer the lowest interest rates, their overall return to investors may be higher due to their tax advantages.

Advantages (pros) of bonds

• Stable returns. The interest payments an investor receives from bonds can result in a steady stream of fixed income over the life of the loan;
• Low risk. Because bonds tend to provide more stable returns than stocks, they can help create a balanced, low-risk portfolio;
• Low correlation with stocks. Some types of bonds are less market dependent than stocks and may be a good option for investors who take less risk, including those who are about to retire or have already retired.

Disadvantages (cons) of bonds

• Risk of default. Another important risk is the default risk. A bond default can result in a loss of principal and interest if the borrower is unable to repay the loan. In general, the probability of default on investment-grade bonds is low;
• Interest rate risk. While bonds are generally safer investments than stocks, they also come with potential risks, one of which is interest rate risk. Interest rates can have a significant impact on bond prices. When interest rates rise, bond prices usually fall, and vice versa.
• Capital appreciation linked to interest rates, not the company: The price of the bonds is more influenced by the general interest rates in the market, and not the performance of its business.

• What Happens To Stocks When Interest Rates Go Up? (Trading Strategy Backtest)
• What Happens To Stocks When Interest Rates Go Down? (Trading Strategy Backtest)

Bond investment strategy – backtest, returns, performance

Let’s backtest bond’s historical performance under the following conditions:

Trading Rules

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For bonds, we have picked these ETFs, which are well diversified, have high liquidity, and a long performance history:

Bond Class Type	ETF Name	ETF Ticker	Weight
Long-term Government Bonds	iShares 20+ Year Treasury Bond ETF	TLT	20%
Short-term Government Bonds	iShares Short Treasury Bond ETF	SHV	20%
Corporate Bonds	iShares iBoxx $ Investment Grade Corporate Bond ETF	LQD	20%
Emerging Markets Bonds	iShares J.P. Morgan USD Emerging Markets Bond ETF	EMB	20%
Intermediate-Term Bonds	Vanguard Total Bond Market ETF	BND	20%

The portfolio’s equity curve:

The portfolio’s underwater curve (drawdowns):

Portfolio monthly and annual returns:

Year	Jan	Feb	Mar	Apr	May	Jun	Jul	Aug	Sep	Oct	Nov	Dec	Yr%
2007	-0.2%	1.2%	-0.4%	0.5%	-0.8%	-0.3%	0.7%	1.3%	0.4%	0.8%	1.8%	-0.0%	5.0%
2008	1.5%	-0.3%	0.5%	-0.1%	-1.1%	-0.1%	0.2%	0.9%	-3.3%	-5.0%	6.2%	9.8%	8.8%
2009	-4.9%	-2.6%	2.1%	0.8%	0.5%	1.1%	2.0%	1.4%	2.1%	-0.6%	1.1%	-1.7%	0.9%
2010	1.0%	0.4%	0.2%	1.4%	0.6%	2.6%	1.2%	3.2%	-0.1%	-0.6%	-1.7%	-1.0%	7.1%
2011	-0.8%	0.6%	0.2%	1.6%	1.5%	-0.6%	2.1%	2.5%	2.1%	0.5%	-0.4%	2.1%	11.9%
2012	0.7%	0.3%	-1.2%	1.7%	1.5%	0.6%	2.5%	0.0%	0.1%	0.3%	0.3%	-0.6%	6.4%
2013	-1.6%	0.6%	-0.3%	2.3%	-3.4%	-2.5%	-0.1%	-1.1%	1.1%	1.3%	-1.0%	-0.4%	-5.1%
2014	1.8%	1.1%	0.4%	1.1%	1.8%	-0.0%	-0.0%	1.9%	-1.4%	1.4%	0.9%	0.2%	9.5%
2015	3.6%	-1.6%	0.4%	-0.7%	-0.9%	-1.8%	1.2%	-0.6%	0.6%	0.5%	-0.2%	-0.6%	-0.2%
2016	1.4%	1.4%	1.5%	0.6%	0.0%	3.3%	1.1%	0.0%	-0.3%	-1.8%	-3.7%	0.5%	3.9%
2017	0.6%	1.1%	-0.1%	1.1%	1.0%	0.1%	0.4%	1.5%	-0.6%	0.1%	0.1%	1.0%	6.2%
2018	-1.3%	-1.7%	1.0%	-1.3%	0.5%	-0.2%	0.5%	-0.0%	-0.3%	-1.6%	0.3%	2.3%	-1.8%
2019	2.0%	-0.2%	2.4%	-0.2%	2.2%	1.9%	0.3%	4.0%	-1.0%	0.1%	-0.2%	0.0%	11.6%
2020	2.7%	1.7%	-2.9%	2.5%	1.3%	1.2%	2.6%	-1.6%	-0.3%	-1.1%	2.2%	0.2%	8.6%
2021	-1.6%	-2.5%	-1.7%	1.3%	0.4%	1.6%	1.3%	0.0%	-1.6%	0.6%	0.2%	-0.0%	-2.1%
2022	-2.6%	-2.1%	-2.4%	-5.3%	0.3%	-2.5%	2.5%	-2.8%	-4.7%	-1.4%	5.2%	-1.1%	-16.1%
2023	4.0%	-2.8%	2.7%	0.4%	-2.3%	N/A	N/A	N/A	N/A	N/A	N/A	N/A	1.8%

Portfolio performance statistics compared to benchmark S&P 500 Total Return index:

Statistical Metric	Portfolio	S&P 500 TR
Annual Return %	3.19%	8.95%
Exposure %	98.47%	100.00%
Risk Adjusted Return %	3.24%	8.95%
Max. drawdown	-23.14%	-55.19%
CAR/MaxDD	0.14	0.16
Standard Deviation	6.22%	22.64%
Sharpe Ratio (3% risk-free)	0.03	0.26

Is it better to invest in stocks or bonds?

At this stage, you might want to ask: what is the best investment – stocks or bonds?

Clearly, history shows that stocks have been the better investment. Does this mean that you should only invest in stocks?

No, it depends on many factors. For example, if you are close to retirement, you might want to reduce your stock portion and allocate more to bonds to reduce risk. Imagine retiring in 2008 only to see your stock portfolio fall 50% in value!

Thus, there is no definite answer. You also have to consider that bonds have mitigated risk in times of financial turbulence:

What happens to bonds when stock market crashes?

When a stock market crashes, most investors would love a diversified portfolio with other assets that might mitigate the losses from stocks.

Historically, bonds have provided that, with a few exceptions (2022 was one of those). Let’s look at why bonds can be a safe haven in times of turmoil on the stock exchange:

1. Flight to safety: During a stock market crash, investors often seek safer investment options, which can include bonds. This increased demand for bonds can lead to a rise in bond prices. When bond prices rise, their yields decrease. Therefore, in some cases, bond prices may increase during a stock market crash.
2. Interest rate impact: Stock market crashes can be accompanied by economic uncertainty, which may prompt central banks to lower interest rates to stimulate the economy. When interest rates decrease, bond prices tend to rise, as existing bonds with higher coupon rates become more attractive. However, this relationship is not guaranteed.

Are bonds safe in a recession?

It’s mostly sovereign bonds that work as risk mitigation assets.

Corporate bonds might be a different matter, though, and not be safe in a recession because of credit risk and sentiment:

1. Credit risk: A severe stock market crash can negatively impact the financial health of companies. Companies facing financial difficulties may compromise their ability to repay their debts, as happened in the financial crisis of 2008. This can increase the risk of default on corporate bonds, especially those issued by weaker or highly leveraged companies. As a result, the prices of these bonds may decline. Treasury bonds might go the opposite way, though.
2. Investor sentiment: Stock market crashes can create panic and a negative sentiment among investors. In such situations, investors may sell off their bond holdings along with stocks, seeking liquidity or to cut losses. This selling pressure can lead to a decline in bond prices.

Stocks and bonds investment strategy – backtest, returns, performance

Is it a good idea to invest in both stocks and bonds?

As mentioned earlier in the article, stocks and bonds can be included in a portfolio. Let’s run a backtest where we invest in all the above-mentioned ETFs. However, we allocate 60% to stocks and 40 to bonds. We previously did a backtest of the 60/40 portfolio, but only with SPY and TLT.

We make the following stock and bond investment strategy and portfolio:

Asset	ETF Name	ETF Ticker	Weight
Large Cap Blend Stocks	SPDR S&P 500 ETF Trust	SPY	12%
Small Cap Blend Stocks	iShares Core S&P Small-Cap ETF	IJR	12%
Large Cap Value Stocks	Vanguard Value Index Fund	VTV	12%
Small Cap Value Stocks	iShares Russell 2000 Value ETF	IWN	12%
International Stocks	iShares MSCI EAFE ETF	EFA	12%
Long-term Government Bonds	iShares 20+ Year Treasury Bond ETF	TLT	8%
Short-term Government Bonds	iShares Short Treasury Bond ETF	SHV	8%
Corporate Bonds	iShares iBoxx $ Investment Grade Corporate Bond ETF	LQD	8%
Emerging Markets Bonds	iShares J.P. Morgan USD Emerging Markets Bond ETF	EMB	8%
Intermediate-Term Bonds	Vanguard Total Bond Market ETF	BND	8%

We get the following equity curve when we backtest the portfolio with the weightings above:

Statistical Metric	Portfolio	S&P 500 TR
Annual Return %	6.1%	8.95%
Exposure %	99.98%	100.00%
Risk Adjusted Return %	6.16%	8.95%
Max. drawdown	-38.1%	-55.19%
CAR/MaxDD	0.16	0.16
Standard Deviation	17.1%	22.64%
Sharpe Ratio (3% risk-free)	0.12	0.26

The allocation to bonds lowers the returns compared to a 100% allocation to stocks, but you get less volatility and drawdowns. Thus, there is no definite answer to what is best: beauty is in the eye of the beholder and which time frame you are considering owning the assets.

Why would an investor choose to invest in stocks instead of bonds?

This question is partially answered in the section above and throughout the article. However, let’s summarize why an investor might choose stocks to bonds:

1. Higher potential returns: Historically, stocks have provided higher average returns compared to bonds over the long term. While stocks can be more volatile and carry higher risk, they also offer the potential for greater capital appreciation and higher dividends.
2. Ownership and growth potential: When you invest in stocks, you become a partial owner of the company. This ownership can give you the opportunity to participate in the company’s growth and success. As the company’s profits increase, the value of its stock may also rise, potentially leading to capital gains. Bondownes have no ownership – they are lenders. This is an important distinction.
3. Diversification and risk management: Investing in stocks allows for greater diversification across different companies and industries. By spreading investments across multiple stocks, investors can reduce the risk of losing all their capital if a single company or sector performs poorly. Bonds, on the other hand, typically offer lower diversification opportunities.
4. Inflation protection: Stocks have historically provided a hedge against inflation. In periods of inflation, companies can often increase prices for their goods and services, leading to higher revenues and potentially higher stock prices. Bonds, especially fixed-rate bonds, may be more vulnerable to the erosive effects of inflation. This happened in 2022 when increased inflation expectations made bonds tumble.
5. Dividend income: Some stocks pay dividends to their shareholders. These periodic cash payments can provide a steady stream of income for investors. While not all stocks pay dividends, bonds generally provide regular interest payments.

Stocks vs. bonds investment strategy – Conclusion

Let’s summarize the main takeaways from this article:

• If you want to get the highest possible return, considering high risks, invest only in stocks. However, you should have at least a ten-year horizon on the investment;
• If you want to preserve your capital, avoid drawdowns and get additional income in line or above inflation, use only bonds;
• You can mix stocks and bonds in your portfolio depending on your investment preferences, goals, and styles. Many passive portfolio strategies mix stocks and bonds;
• Our backtesting substantiated the thesis that stocks are more profitable and volatile while bonds are less profitable and less volatile. Stocks have more drawdowns, while bonds have much less.

FAQ:

What is the ‘Sell in May and go away’ strategy?

The ‘Sell in May and go away’ strategy is a seasonal pattern suggesting that investors should sell their stocks in May and reinvest in November. In the context of international stock ETFs, the strategy explores whether the stock market performs better during winter months in various countries, such as Australia and Latin America.

What are the trading rules for the “Investing only in Winter”?

The trading rules are straightforward. From November until April, investments are made in countries experiencing winter, such as the United States, Japan, and Europe. From May until October, the focus shifts to countries in winter, such as Australia, South Africa, and Latin America.

How was the backtest conducted for the ‘Investing only in Winter’?

The backtest involved creating two portfolios with equally weighted ETFs representing winter and summer regions. Performance metrics such as Compound Annual Growth Rate (CAGR), Maximum Drawdown, and Standard Deviation were calculated. Despite the hypothesis, the strategy did not perform as expected, with insights provided into its shortcomings.