Stocks vs bonds: What works in different market conditions?

"Stocks or bonds?" sounds like a simple choice. But the comparison itself can be too narrow. A globally diversified equity investment on one side and a German government bond on the other do not represent the full range of opportunities within these two asset classes.

Inflation does not settle the question either. It can put pressure on bonds, yet the associated market adjustments can also change the starting point for a new investment. After prices fall, the potential returns may look different, even while inflation remains a concern.

What matters is the interplay between an investor's time horizon, capacity to absorb losses, the investments being considered and prevailing market conditions. How do these factors help investors make a more meaningful comparison between stocks and bonds?

• Investment horizon: When do stocks or bonds make sense?
• Why is there more to the bond market than German government bonds?
• How do inflation and rising interest rates affect bonds?
• Why can bonds become attractive again despite inflation?
• How can stocks and bonds work together in a portfolio?

An investment horizon is the length of time money can remain invested. When weighing stocks against bonds, the planned end date is only part of the picture. It is just as important to consider whether the money might be needed along the way and whether losses would be financially manageable. A long-term plan is of little use if an investment has to be sold during a downturn.

Long investment horizon: Investors who can leave their money invested for 20 years or more can place greater emphasis on the long-term return potential of stocks. However:

• Risk still matters: Holding stocks for a long time does not make them risk-free.
• Global diversification: This applies to globally diversified equity investments, not individual stocks.
• Broad risk diversification: Diversification means allocating capital across different investments to spread risk. Even broad diversification does not rule out losses.

Japan's Nikkei 225 shows why a long holding period alone offers no guarantee of safety. The index is not globally diversified, but it comprises shares in 225 selected Japanese companies across a range of industries. In 1989, Japan was the world's second-largest economy, measured by nominal gross domestic product in US Dollar terms.

On 29 December 1989, the Nikkei 225 reached a then-record closing level of 38,915.87 points. Substantial price losses followed. It took more than 34 years for the index to surpass that peak: Only on 22 February 2024 did it close at a new record high of 39,098.68 points.

The example illustrates how price losses can persist for decades, even when investments are spread across many companies in a major economy. A long holding period alone therefore does not guarantee that losses will be recovered within an investor's own time horizon. The quoted levels refer to the price index in yen, excluding dividends and without adjusting for inflation. They show price performance, not the total return on an investment.

Shorter investment horizon: With a shorter investment horizon, the risk of facing losses when the money is needed becomes more important. In practice:

• No automatic alternative: A short investment horizon does not automatically make bonds a suitable alternative to stocks.
• Assess each investment: A bond's specific features and risks, including price risk and interest rate risk, must also be assessed against the time available.

Ultimately, it is not just the planned holding period that matters, but also how much flexibility an investor retains during that time and what losses they can absorb along the way.

Stocks and bonds differ first in the rights they confer. 

• A stock represents an ownership stake in a company. 
• A bond, by contrast, makes its holder a creditor, with rights set out in the bond's terms and conditions. Governments and companies are among those that can issue bonds. They are known as issuers.

These basic differences do not, however, determine which investment is appropriate in a particular situation. An international stock index such as the MSCI World represents a large number of companies. A German government bond, by contrast, represents exposure to a single sovereign issuer. The comparison therefore puts a broad view of the stock market alongside a narrow slice of the bond market.

The bond market spans different segments and niches. Their potential returns and risks cannot simply be equated with those of a German government bond. Market inefficiencies and particular investment opportunities may also arise in certain areas. That does not mean those areas should always be preferred, nor that their opportunities are equivalent to those offered by stocks.

A meaningful comparison therefore starts with defining exactly which equity investment and which bonds are being considered. A view on German government bonds does not automatically apply to other bonds. Equally, an attractive opportunity in one segment cannot be used to draw conclusions about the entire bond market.

Inflation can put pressure on bonds in two distinct ways. The first concerns the purchasing power of the capital invested and the interest payments. The second concerns potential changes in market prices. Both effects can occur at the same time, but they should not be confused.

• Loss of purchasing power: The first effect is best understood by distinguishing between nominal and real values. A nominal amount is stated without allowing for changes in prices. A real value, by contrast, reflects purchasing power. As the general price level rises, the same amount of money buys fewer goods and services.

  For a bond with payments fixed in nominal terms, this can reduce the purchasing power of both the interest and the eventual repayment. Inflation alone does not reduce the nominal amount owed. It does, however, change its economic value to the investor because the money buys less. Interest payments can help offset this loss of purchasing power, but may not fully compensate for it.

• Price losses from rising interest rates: The second effect concerns the bond's market price. Central banks may respond to rising inflation by raising interest rates. If the market rates relevant to comparable bonds rise, existing fixed-rate bonds may come under pressure. When new, comparable bonds offer higher interest rates, an existing bond with a lower fixed rate becomes relatively less attractive.

  Its price may therefore fall even though its agreed interest payments remain unchanged. The possibility of price losses as interest rates change is known as interest rate risk. For an investor who sells before maturity, a lower market price can directly affect the proceeds from the sale.

The distinction is straightforward: A loss of purchasing power affects the real value of the payments, while an interest rate-driven price decline affects the bond's market price. High inflation, however, is not the same as inflation that is still rising. A high inflation rate does not automatically mean that further interest rate increases and additional price losses lie ahead. Adjustments that have already taken place matter too.

After a market adjustment, investors face a different starting point. A bond whose price has fallen can be bought at a lower price. This changes the relationship between the amount invested and the agreed future payments. That is where the perspective shifts from the impact on existing holdings to the terms available for a later purchase.

Understanding this relationship requires distinguishing between a bond's coupon and its yield.

• Coupon: The coupon is the agreed interest rate on a bond's face value, the specified amount used as the basis for calculating interest. For a fixed-coupon bond, this rate remains unchanged even as its market price fluctuates.
• Bond yield: Yield to maturity takes account of the purchase price, remaining time to maturity and scheduled repayment, as well as the interest payments.

If the purchase price falls while the agreed payments remain unchanged, the calculated yield rises. The coupon does not have to increase for this to happen. A price decline can therefore hurt an existing holding while increasing the calculated yield available to someone buying at the lower price. There is no contradiction: The starting prices are different.

Changes in interest rates and selling pressure can significantly alter conditions in the bond market. Individual bonds may then warrant a fresh assessment even if inflation remains a concern. The question is no longer simply whether inflation hurts bonds, but what return potential is available after the adjustments that have already taken place.

This does not mean that every higher bond yield compensates for a loss of purchasing power. Nor does a lower price prove that a bond is cheap or low-risk. A calculated yield is not a guaranteed investment outcome. Whether the agreed payments are actually made, and the price achieved if the bond is sold, remain crucial to the result.

None of this amounts to an automatic buy signal. Market adjustments can vary in speed and scale. A rise in interest rates or a fall in prices does not, on its own, reliably indicate that the adjustment is over. Inflation is therefore neither a blanket reason to avoid bonds nor a signal that investors should necessarily buy after particular market movements.

Taking a long-term view of stocks and assessing specific bond segments are not mutually exclusive. Both asset classes can be held together in a portfolio. Multi asset strategies take this approach by combining different investments across asset classes. They may include other assets alongside stocks and bonds.

This reframes the original question. Rather than declaring stocks or bonds the outright winner, the focus shifts to the role each can play in the portfolio. Depending on how the strategy is designed, their weightings can be adjusted rather than permanently excluding either asset class.

That does not imply a universally appropriate allocation to stocks or bonds. Nor does flexible management guarantee that every market environment will be assessed correctly or that the best timing will always be achieved. It allows a portfolio to be positioned in different ways, but does not replace careful consideration of investment horizon, capacity to absorb losses and the specific investment opportunities available.

A very long investment horizon, global diversification and the ability to absorb losses along the way make a case for considering the return potential of stocks. Bonds, meanwhile, should neither be reduced to German government bonds nor judged solely by the inflation rate. Their diversity and the market adjustments that have already taken place both need to be considered.

The key shift in perspective is this: What puts pressure on existing bond holdings can change the terms available for a later investment. Rather than treating stocks and bonds as an either-or choice, it is more useful to ask which specific investments fit the time available, the risks an investor can bear and prevailing market conditions.

Balanced funds and multi asset funds combine different asset classes in a single fund. The breadth of the investment universe and the flexibility to adjust allocations depend on the strategy. Read more in our article "Balanced Funds vs Multi Asset Funds".