When Do Bonds Outperform Stocks?
The other reason to favor bond investments over stock investments is that occasionally bonds will have better returns than stocks. Over the long-term, stocks always outperform bonds, but in the short-run, that is not always the case. When investors flee riskier stock investments for the relative safety of bonds, bond prices shoot up. In fact, one of the central concepts upon which diversification depends is that not all asset classes move in the same direction at the same time. While the stunning completeness of the real estate bubble popping sent all asset classes including stocks and bonds falling at the same time, it doesn't happen very often.
Generally, as interest rates rise, bond prices fall. No one wants to pay $1,000 for a bond paying 4.0% when they can buy an equivilent risk bond paying 5.0% for $1,000. In order to sell the 4.0% bond, the seller must sell at a discount. Typically the discount is approximately the amount that would cause the bond to yield 5.0% based upon the lower price the buyer will pay.
Conversely as interest rates fall, bond prices rise. In this case, when interest rates fall to 3.0%, bonds paying 4.0% are no longer being issued. The seller will therefore demand a premium that is approximately the amount that would make the bond yield 3.0% for the buyer.
Therefore, the time to favor bonds over stocks as investments is when the investor feels that interest rates will be trending downward. Coincidentally, falling interest rates are most common when the economy stutters and business revenues and profits dry up, making their stock less valuable.
With interest rates at historic lows, now is not the time to increase an investor's allocation to bonds. However, the volatility of stocks is clearly not going away either. For long-term investors, sticking with a carefully constructed diversified portfolio is still the best solution. For short-term investors, alternative income investments are looking more attractive.
Until interest rates rise to some level that can be considered "normal" or otherwise sustainable for an extended period of time, bonds are unlikely to outperform stocks.