Are Mutual Funds Riskier Than Bonds?

The adage, “nothing ventured, nothing gained,” is valuable advice, but the key to success with investing is knowing your financial objectives and risk tolerance first, and then investing accordingly. For this reason, many first-time investors focus on mutual funds and bonds before putting money into individual stocks. However, which of these two relatively safer options makes the most sense?

Mutual funds are riskier than bonds because, with bonds, investors have access to credit ratings and are protected by bankruptcy laws. Therefore, investors have the corporation’s credit score to gauge risk, and in the event of bankruptcy, corporations are required by law to pay bond investors first.

The rest of this article will explain a few topics related to this question in great detail, including defining the difference between mutual funds and bonds, how investors profit from bonds, and how to further minimize risk with investing. So let’s get started!

How Are Mutual Funds and Bonds Different?

If you “venture” outside of your comfort zone by purchasing high-risk stocks, for example, you are likely to lose money by leaving too early. 

This area is where mutual funds and bonds are similar. Because the mutual fund is made up of stocks, bonds, and other securities, most investors do not see substantial changes in the fund that may go above their risk tolerance.

Bonds are subject to interest rates but are generally less volatile, so they will not show a considerable shift in profit or loss at any given point. 

Both mutual funds and bonds tend to be safer investments than stocks, but there are differences between the two securities. For example, mutual funds use money from a large pool of investors to purchase a variety of securities. 

On the other hand, bonds are one of the ways governments and corporations secure capital for growth, infrastructure, and other needs.

What makes bonds safer is that government agencies and well-established corporations often offer them. More often than not, the money raised by the bonds is used to make improvements or fund ventures that will make the company more valuable.

The other feature that makes bonds enticing to some is that when the bond matures, the investor is guaranteed to receive the bond’s face value as long as the issuer does not go into default. Although mutual funds invest in bonds as a portion of the fund, bond payments are divided among the pool of investors rather than paid directly to the bond owner.

Another difference between mutual funds and bonds is the laws that govern them. 

However, again, the mutual fund is a combination of securities, so while it will enjoy the benefits of the laws that pertain to bonds, it is still at risk for the other securities that make up the fund.

For example, if the bond issuer goes into default and files for bankruptcy, the laws provide a measure of protection to the investor because bond investors must be paid before stock investors in the event of default.

A mutual fund may have stocks and bonds from a company that files for bankruptcy, making mutual funds a riskier investment than bonds.

When Should You Choose Bonds for Your Portfolio?

Before purchasing a high number of bonds, it is essential to remember that If bonds were failproof and consistently profitable, many investors would elect this option exclusively even if stocks offer the potential of a greater return. 

So, although there is a measure of safety in bonds, your portfolio should remain diversified. The following are some terms to consider when purchasing bonds.

• The term bond bubble describes an economic environment in which the bond’s face value is above its true worth. Kenny Ried from “The Balance” explains that this bubble occurs due to the “widespread” belief that no matter how high prices might be now, someone else is likely to pay an even higher price in the near future.”
• The term negative correlation describes the situation in which one equity increases while the other decreases. As such, a negative correlation is crucial for a diversified portfolio.

Understanding these terms helps you see why bonds are equally essential but should not exclusively make up any financial portfolio.

How Do Investors Make Money With Bonds?

Remember that mutual funds are made up of stocks, bonds, and other securities. 

Bonds are loans you make to governments and corporations to help them raise capital for necessary improvement. Investors make money with bonds by holding onto them until maturity and then reaping the interest they earn. 

After that, payments are made to the investor for the bond’s life, usually twice a year.

Another way to make money with bonds is to sell it before it matures at a price higher than you paid for it. Several events can make the bond increase in face value. 

First, the corporation’s credit rating can go up, signaling to lenders that the bond will be paid in full at maturity.

Second, when interest rates on new bonds go down, the value of existing bonds goes up.

There Is a Downside to Investing in Bonds

The downside to bonds is that they have lower returns and are influenced by inflation. Still, bond payments are provided to investors yearly for the life of the loan, so bonds provide income that can be used to build the portfolio further.

Another risk is termed “duration,” which is the bond’s reaction to changing interest rates. Basically, the bond’s price will rise and fall with prevailing interest rates, which is a potential risk and a potential reward. 

How To Further Minimize Risk With Investing?

Investing is risky, but so is placing your money in a savings account. Although the savings account won’t lose any part of the initial investment, the low interest rates paid on that money cause you to lose future wealth. 

The best way to minimize your risk when investing is to educate yourself on all types of investments and then get into the investment game based on your financial goals and risk tolerance.

Amazon.com has several books for both beginner and professional beginners. The following are some of our favorites:

• Investing for Kids: How to Save, Grow, and Earn Money: This book is definitely for children using Mr. Finance and Investing Woman to illustrate the concepts, but it is a quick and worthwhile read for any age investor.
• The Everything Guide to Investing in your 20s and 30s: This step-by-step guide to investing covers mutual funds, bonds, stocks, cryptocurrencies, and other securities and provides a brief section on how to minimize your tax burden. 
• The Stock Market Investing Bible: This is six books in one. It offers a Kindle edition, and at 642 pages, it is a hefty read. Book Two discusses mutual funds, and Book Three discusses bonds.
• All About Bonds, Bond Mutual Funds, and Bond ETFs, 3rd Edition: This is a must-have for all bond investors because it discusses both old and new bond types.
• Investing All in One for Dummies: This is another hefty but essential read. At 552 pages, it can seem daunting; however, it is eight books in one. Like all of the For Dummies books, it is written using beginner language, and it has something for all investors, regardless of age.
• The Intelligent Investor: This has been in publication since 1949, and it remains a mainstay for all levels of investors. At 642 pages, it, too, is a reference book that helps investors self-educate.

Conclusion

Nothing is a “sure thing” when you invest, but bonds are certainly a safer option much of the time, followed closely by mutual funds. The latter carries more risk only because the same laws that cover bonds do not apply to mutual funds. 

In addition, bond investors receive their investment capital back when the bond matures, while mutual funds offer no such guarantee. 

Regardless of your choice, however, the riskiest investment is to hold your money in a savings account while you wait to be sure you are ready to invest because you are risking your earning potential.