Why Stocks Generally Outperform Bonds

Term Definition Example Sentence

volatility the degree of variation or fluctuation in a The stock market experienced high
(noun) financial market or investment volatility during the economic crisis.

yield (noun) the income generated by an investment, The bond has a yield of 5%, meaning it will
typically expressed as a percentage of the generate a 5% return on investment.
investment's cost

discount rate the interest rate used to determine the A higher discount rate reduces the present
(noun) present value of future cash flows value of a bond.

default (verb) to fail to fulfill an obligation, especially a If the borrower fails to make loan
financial one payments, they will default on the loan.

creditworthine the assessment of how likely a person or The bank considers the applicant's
ss (noun) entity is to repay their debts creditworthiness before approving a loan.

Why Stocks Generally OutperformBonds

Stocks and bonds are two common investment options, but they have distinct characteristics.
Stocks represent partial ownership in a company, allowing stockholders to share in the company's
earnings and profits. On the other hand, bonds are like loans, where investors lend money to
companies or governments in exchange for a fixed return and a promise to repay the principal at a
later date. While stocks offer the potential for higher returns, they also come with more risk and
volatility compared to bonds.

The price of a stock is influenced by the company's earnings. If the earnings continue to rise, the
stock price usually increases as well. This can happen because the company reinvests its earnings
or buys back its own stock. Regardless of how the earnings are used, if they keep growing, the
stock price tends to go up too. However, if a company fails, stockholders may lose their entire
investment. In contrast, bondholders have a greater chance of recovering some or all of the money
they lent.

Several factors contribute to the volatility of bonds. One of these factors is expected inflation. The
higher the expectation of inflation, the higher the yield or return that bond buyers will demand.
Another factor is the discount rate used to calculate the present value of the bond. The higher the
expected inflation, the higher the discount rate, and therefore the lower the present value of the
bond. Additionally, the longer the time until the payment is made, the more the discount rate is
applied, resulting in a lower present value. Bond payments may be fixed, but their present values
fluctuate due to changing interest rates.

The discount rate used to determine the value of a bond is not solely based on expectations of
inflation. The risk of the bond issuer defaulting also affects the discount rate. If there is a higher
risk of default, the discount rate applied will increase, ultimately affecting the current value of the
bond. Each investor uses their own discount rate based on their expectations of inflation and their
opinions on the bond issuer's creditworthiness. These factors contribute to their personal
assessment of risk.

When it comes to stocks, the return is not fixed like with bonds. The relevant return from stocks is
referred to as free cash flow, but in practice, the market focuses on reported earnings. However,
earnings can vary greatly and are unknown. They may grow rapidly, slowly, not at all, or even
decline. To calculate the present value of stocks, one must make an educated guess about future
earnings, which can continue for many years. Additionally, the expected return from stocks is
influenced by an ever-changing discount rate. As a result, stock prices tend to be more volatile
compared to bond prices due to fluctuations in both the earnings stream and the discount rate
used to calculate the present value of stocks.

[1] This reading passage was generated based on this original text:
2022/12/4 15:07 Why Stocks Generally Outperform Bonds

Reading Summary
- Stocks represent partial ownership in a company, allowing stockholders to share in the
company's earnings and profits.
- Bonds are like loans, where investors lend money to companies or governments in exchange for
a fixed return and a promise to repay the principal at a later date.
- Stocks offer higher returns but also come with more risk and volatility compared to bonds.

Multiple Choice Questions

Question #1 Question #2 Question #3
According to the text, what is What is one characteristic of What is the main idea of this
one factor that contributes to stocks mentioned in the text? passage?
the volatility of bonds?

A. Expected inflation A. Fixed return A. Stocks and bonds are

B. Company earnings B. Promise to repay both risky investments.
C. Stock prices principal B. The price of a stock is
D. Bond issuer C. Higher risk and volatility influenced by company
creditworthiness D. Present value fluctuates earnings.
C. Bonds have a fixed
return while stocks do
not.
D. Stocks are more volatile
than bonds.
Short Answer Questions
Question #1 What are the characteristics of stocks and bonds?

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Question #2 What factors contribute to the volatility of bonds?

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Question #3 Why are stock prices more volatile compared to bond prices?

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Open Ended Questions

Reflect on your own investment preferences and risk tolerance. How does the
Question #1 information in the text about stocks and bonds influence your decision-making?

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Think about a real-life example where you or someone you know has invested in
Question #2 stocks or bonds. How did the characteristics of these investments align with
what you learned from the text?

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Consider the concept of risk and reward in investing. How do you balance the
Question #3 potential for higher returns with the increased risk and volatility associated with
stocks, as compared to the more stable nature of bonds?

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This Diffit resource was created by Li Yang