Stocks or bonds? Investors keep asking this question. Perhaps now especially that stocks have weakened, bonds sometimes offer attractive returns, at least in nominal terms. But how should investors compare these two classes of assets?
The risk/return profile of stocks and bonds is fundamentally different. While the upside potential of stocks is virtually endless at least, bonds’ potential is limited by the amount owed.
On the other hand, the downside risks are similar: a complete loss of both stocks and bonds is possible. However, in the event of a company’s bankruptcy, bondholders are better off than stockholders. Because of the capital structure, lenders (bond holders) are compensated in front of equity lenders (equity holders).
Equity risk premium as a means of comparison
So with stocks, investors take on more risk, through thick and thin. This equity risk should be offset by a premium. Unfortunately, while the concept of the equity risk premium is simple and straightforward, there is no single definition.
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