Chapter 17: Problem 4

Which has a higher average return over time: stocks, bonds, or a savings account? Explain your answer.

Short Answer

Expert verified

Based on historical data, stocks have had the highest average return over time, around 10%, compared to bonds with an average return of about 6%, and savings accounts with significantly lower returns, currently averaging 0.05%. However, stocks come with higher risk and volatility, while bonds offer moderate returns with less risk, and savings accounts provide the lowest returns but are the safest investment option. It is essential to consider individual financial goals and risk tolerance when making investment decisions.

Step by step solution

Define the terms

Stocks represent partial ownership of a company, and their value fluctuates based on the company's performance and market conditions. Bonds are essentially loans made to a company or government, which pay interest and are generally considered a safer investment than stocks. Savings accounts are secure, low-risk accounts offered by banks and credit unions that pay interest on the balance.

Analyze historical returns of stocks

The long-term return of stocks can vary depending on the specific market and time period being analyzed. For example, the historical average annual return for the S&P 500 (an index of 500 of the largest U.S. stocks) from 1928 to 2020 is around 10%. However, this does not account for inflation, taxes, or fees, and individual stocks may have vastly different returns.

Analyze historical returns of bonds

The historical return of bonds also varies depending on the type of bond, the issuer, and the time period. For example, the historical average annual return for U.S. government bonds from 1928 to 2020 is around 6%. Corporate bonds typically have higher returns but carry more risk. Keep in mind that bond yields can be influenced by factors such as interest rates and the creditworthiness of the issuer.

Analyze historical returns of savings accounts

Savings account interest rates are generally much lower than the returns of stocks or bonds. In the United States, the average interest rate on a savings account has hovered around 0.05% in recent years. Historically, interest rates were higher, but they have declined significantly over time due to various economic factors.

Compare and explain

Based on historical data, stocks have had the highest average return over time compared to bonds and savings accounts. However, this higher return comes with a higher level of risk and volatility, as stock prices can fluctuate dramatically. Bonds offer a moderate return with less risk, while savings accounts provide the lowest return but are considered the safest investment option. In conclusion, if the goal is to maximize average returns over time, stocks have historically outperformed bonds and savings accounts. However, it is essential to consider both the risks and the individual investor's financial goals and risk tolerance when making investment decisions.