Stocks vs bonds: how each asset class behaves and how to combine them

Stocks and bonds are the two foundational asset classes in nearly every multi-asset portfolio. They behave differently, respond to different drivers, and the question for any investor is not which is universally better but how the two should be combined for the relevant horizon and risk tolerance.

How stocks work

A stock represents an ownership share in a company. The investor is entitled to a residual claim on profits (paid as dividends or retained for reinvestment) and benefits—or suffers—from changes in the market's view of those future earnings. Total return on equity has two components: capital appreciation as the share price rises, and dividend income paid to shareholders. Both components compound, and over long horizons the dividend component is a meaningful share of the total.

Equity prices respond to changes in expected earnings, in the discount rate applied to those earnings, and in the risk premium investors demand for bearing equity risk. Each of these moves over time, which is why equity returns are volatile and drawdowns are common—and large.

Long-run global equity returns have been approximately 5–6% per year in real terms across more than a century of data (Dimson, Marsh, & Staunton). The same data show that drawdowns of 30% or more occur roughly once a decade, with deeper drawdowns (50% or more) in 1929–1932, 2000–2002, and 2007–2009.

How bonds work

A bond represents a loan from the investor to the issuer. The issuer commits to pay a defined coupon at scheduled intervals and to return the principal at maturity. Total return on a bond comprises the coupon (paid as cash) and any change in the bond's price between purchase and sale.

Bond prices respond mainly to changes in interest rates, in inflation expectations, and—for corporate or emerging-market bonds—in credit conditions. Falling rates lift bond prices; rising rates depress them. Duration measures the magnitude of this sensitivity. The longer the duration, the larger the price response to a given rate change.

Long-run global government bond returns have been approximately 1.7% per year in real terms across the same century (Dimson, Marsh, & Staunton). Drawdowns are smaller and shallower than for equities in normal regimes—but not always: the 2022 cycle, in which long-duration bond ETFs fell more than 30%, was one of the deepest fixed income drawdowns in modern data.

Key differences

The return profile differs structurally. Equities have higher expected returns and higher volatility; bonds have lower expected returns and lower volatility in most regimes. The risk premium for bearing equity risk has historically been roughly 4 percentage points per year above the bond return on average—the equity risk premium.

The correlation between stocks and bonds is regime-dependent. Through most of the post-1990 period, US stock and bond returns have been negatively correlated: bonds rallied when equities fell, providing diversification in equity drawdowns. In the 1970s and again in 2022, both fell together as inflation surged—the correlation flipped positive, and the diversification benefit disappeared. Investors building portfolios on the assumption of negative stock-bond correlation should be aware that the assumption holds in some regimes and not in others.

Liquidity, taxation, and currency exposure also differ across the two asset classes, particularly when held through ETFs in a non-domestic currency. These differences are typically smaller than the return-and-risk differences but matter for the after-tax, after-cost outcome.

Trade-offs: when each makes sense

The case for a higher equity allocation is strongest at long horizons, where the volatility of equities matters less because there is more time for expected returns to compound through drawdowns. The case for a higher bond allocation is strongest where capital preservation, drawdown limitation, or near-term cash flow needs dominate. A 30-year-old saving for retirement and a 65-year-old beginning withdrawals face different problems and warrant different allocations.

Most investors hold both, in proportions calibrated to their horizon, risk tolerance, and capacity for loss. The 60/40 portfolio—60% equity, 40% fixed income—is the canonical balanced allocation. It is not a magic combination, but it captures most of the diversification benefit available between the two classes and serves as a useful reference point. Variants from 80/20 to 30/70 cover most reasonable horizons.

The pfolio perspective

pfolio supports portfolios that combine equities and fixed income in any user-defined proportion, accessing both asset classes through ETFs and (for fixed income) futures. Construction methods range from equal weight or 60/40 to mean-variance optimisation and Hierarchical Risk Parity. Asset class exposure and performance are tracked across holdings in pfolio Insights.

Related articles

• Equity investing explained: stocks, ETFs, and global market exposure
• Fixed income investing explained: bonds, yield, and stability in a portfolio
• The 60/40 portfolio: origins, performance record, and when it stops working
• Portfolio diversification: why spreading risk across asset classes beats spreading across stocks