Why Stocks Generally Outperform Bonds

Stocks provide greater return potential than bonds, but with greater volatility along the way. Bonds are issued and sold as a “safe” alternative to the generally bumpy ride of the stock market. Stocks involve greater risk, but with the opportunity of greater return. Let’s take a closer look at why stocks tend to outperform bonds.

Key Takeaways

• Bond rates are lower over time than the general return of the stock market.
• Individual stocks may outperform bonds by a significant margin, but they are also at a much higher risk of loss.
• Bonds will always be less volatile on average than stocks because more is known and certain about their income flow.
• More unknowns surround the performance of stocks, which increases their risk factor and their volatility.

Understanding Stocks and Bonds

For an example of stocks and bonds in the real world, you can consider that bonds are essentially loans. Investors loan funds to companies or governments in exchange for a bond that guarantees a fixed return and a promise to repay the original loan amount, known as the principal, at some point in the future.

Stocks are, in essence, partial ownership rights in the company that entitle the stockholder to share in the earnings that may occur and accrue. Some of these earnings may be paid out immediately in the form of dividends, while the rest of the earnings will be retained. These retained earnings may be used to expand operations or build a larger infrastructure, giving the company the ability to generate even greater future earnings.

Other retained earnings may be held for future uses like buying back company stock or making strategic acquisitions of other companies. Regardless of the use, if the earnings continue to rise, the price of the stock will normally rise as well.

Note

From 1928 to 2024, the S&P 500, representing U.S. large-cap stocks, achieved an average annual return of approximately 10.2%, while 10-year U.S. Treasury bonds returned around 5.3% annually during the same period.

Reasons Why Stocks Generally Outperform Bonds

We’ll start with the obvious: in any given period, given the right conditions, bonds can outperform stocks. However, over the long run and generally speaking, stocks tend to return higher returns than bonds. Here’s why:

Higher Growth Potential

Stocks represent ownership in companies, which means that investors have a share in the profits and success of those businesses. Over time, companies that grow their revenue and earnings tend to see their stock prices rise. This growth is driven by innovation, market expansion, and operational efficiency, all of which are rewarded in the stock market and don’t exist in the bond market.

Inflation Hedge

Inflation erodes the purchasing power of money, and fixed-income securities like bonds are particularly vulnerable to this effect. Stocks, however, are often considered a better hedge against inflation because companies can increase their prices and revenues in response to rising costs. For example, think about how a restaurant could start to face higher costs for its raw ingredients. They could, in theory, start charging higher prices which would increase their revenue.

Dividend Income and Capital Appreciation

Stocks provide a dual benefit: dividend income and capital appreciation. This combination of growing income and rising value makes stocks a more attractive option for long-term wealth creation. Whereas a bond is a fixed payment amount, there are just more options for stocks to grow (value-wise or cash payout-wise).

No Maturity Constraints

Unlike bonds, which have a fixed maturity date, stocks do not have an expiration. This allows investors to hold onto their shares indefinitely and benefit from long-term growth without the need to reinvest principal when security matures.

Greater Liquidity

Speaking at a high level, stocks are generally more liquid than bonds, meaning they can be easily bought or sold on major exchanges with minimal price disruption. This high level of liquidity is pretty important for investors who may need to access their funds quickly. Because there’s an added perk of being able to buy and sell stocks easily, the value of stocks may be just a bit higher because of this benefit.

Risk Premium

We’ll talk more about risk and volatility later; for now, we’ll just mention that stocks are riskier than bonds due to market volatility, the potential for company-specific issues, and economic downturns. For this reason, stockholders demand higher returns in favor of taking on that risk.

Tax Advantages

Sometimes, capital gains from stocks are taxed at lower rates than the ordinary income generated by bonds. For instance, long-term capital gains in the U.S. are often taxed at a maximum rate of 20%, while bond interest is taxed as regular income. In 2025, this bond interest could face tax rates as high as 37% for high earners.

Note

For any given period, you may have higher returns with bonds than stocks. For example, Baa corporate bonds outperformed the S&P 500 (inclusive of dividends) by over 10% in 2011.

Factors to Price Growth/Volatility

If a bond pays a known, fixed rate of return, what causes it to fluctuate in value? Several interrelated factors influence volatility.

Inflation and the Time Value of Money

The first factor is expected inflation. The lower or higher the inflation expectation, the lower or higher, respectively, the return or yield bond buyers will demand. This is because of a concept known as the time value of money, which revolves around the realization that a dollar in the future will buy less than a dollar today because its value is eroded over time by inflation. To determine the value of that future dollar in today’s terms, you have to discount its value back over time at some rate.

Discount Rates and Present Value

To calculate the present value of a particular bond, therefore, you must discount the future payments from the bond, both in the form of interest payments and return of principal. The higher the expected inflation, the higher the discount rate that must be used, and thus the lower the present value.

In addition, the farther out the payment, the longer the discount rate is applied, resulting in a lower present value. Bond payments may be fixed and known, but the constantly changing interest-rate environment subjects their payment streams to a constantly changing discount rate and thus a constantly fluctuating present value. Because the original payment stream of the bond is fixed, the changing bond price will change its current effective yield. As the bond price falls, the effective yield rises; as the bond price rises, the effective yield falls.

More Factors Influencing Bond Value

The discount rate used is not just a function of inflation expectations. Any risk that the bond issuer may default (fail to make interest payments or return the principal) will call for an increase in the discount rate applied, which will impact the bond’s current value. Discount rates are subjective, meaning different investors will be using different rates depending on their own inflation expectations and opinions about the bond issuer’s creditworthiness that factor into their own personal risk assessments. The present value of the bond is the consensus of all these different calculations.

The return from bonds is typically fixed and known, but what is the return from stocks? In its purest form, the relevant return from stocks is known as free cash flow, but in practice, the market tends to focus on reported earnings. These earnings are unknown and variable. They may grow quickly or slowly, not at all, or even shrink or go negative.

To calculate the present value, you have to make the best guess as to what those future earnings will be. To make matters more difficult, these earnings do not have a fixed lifespan. They may continue for decades and decades. To this ever-changing expected return flow, you are applying an ever-changing discount rate. Stock prices are more volatile than bond prices because calculating the present value involves two constantly changing factors: the earnings stream and the discount rate.

Types of Stocks and Types of Bonds

In the stock market, growth stocks and value stocks represent two distinct strategies. Growth stocks are shares of companies expected to grow their earnings at a faster rate than the market average. Value stocks are shares of companies that are undervalued by the market.

Growth companies often reinvest profits into expansion, leading to higher stock price appreciation over time. Value stocks, though maybe without “high prices”, may be more steady with better dividend payouts due to stable earnings. The important part here is that not all stocks (i.e. not all companies) are equal. Some types of stock will appreciate faster, while others may not rise that much in price.

The same can sort of be said about bonds. Bonds also have categories that cater to varying investment needs. Government bonds, such as U.S. Treasuries, are considered among the safest investments because they are backed by the full faith and credit of the government. These bonds tend to have lower yields due to their low-risk nature. On the other end of the spectrum, companies can issue bonds, and these are typically riskier with higher returns. Therefore, based on what you’re invested in, it’s entirely possible to get higher returns from bonds if you’re invested in riskier assets.

Why Do Stocks Typically Outperform Bonds in the Long Run?

Stocks generally outperform bonds because they represent ownership in companies, allowing investors to benefit from corporate earnings and market growth. Over time, the compounding effect of reinvested profits and dividends gives stocks a significant edge in total returns.

Why Are Bonds Considered Safer Than Stocks?

Bonds are generally safer because they provide fixed interest payments and the return of principal at maturity. In addition, government bonds, particularly U.S. Treasuries, are backed by the government, which significantly reduces the risk of default.

Why Do Some Investors Prefer Bonds Despite Stocks’ Higher Returns?

Many investors prefer bonds due to their lower volatility and predictable income, especially those with lower risk tolerance or shorter investment horizons. Behavioral factors like risk aversion and loss aversion also drive the preference for bonds. Some people just prefer peace of mind in exchange for lower returns.

How Should an Investor Decide Between Stocks and Bonds?

The decision depends on factors like risk tolerance, time horizon, and financial goals. Younger investors with a long-term outlook may favor stocks for growth, while retirees or risk-averse individuals may allocate more to bonds for stability and income. People closer to retirement simply can’t afford to lose as much capital, while younger investors have time to replace lost capital if they do experience losses.

The Bottom Line

Stocks generally outperform bonds in the long-term. They tend to have better growth potential as they’re tied to corporate earnings, potential dividend cashflow, and market appreciation. They also tend to carry more risk and uncertainty.