Investors are often told to buy both stocks and bonds in order to diversify.
But what is the actual difference between the two?
Put simply, stocks are shares of companies that represent part ownership. When you buy a stock, you become a part-owner of the business.
However, bonds represent debt, meaning that you are effectively lending money that must be paid back to you, with interest.
Companies can sell stocks and bonds to investors to raise money for various purposes. Stocks can only be sold by companies, but bonds can also be sold by other entities, such as cities and governments.
Stocks are considered riskier than bonds. But they also tend to much more profitable over the long-term.
Below are more details about stocks and bonds, as well as the differences and similarities between them.
Stocks represent part ownership in a company
When you buy a stock, it means you are purchasing a small percentage of the company. Stocks are also called shares or equity.
If a company has one hundred thousand outstanding shares, an investor who buys a thousand shares will effectively own 1% of the company.
It means that the investor will technically be entitled to 1% of the company’s future earnings and cash flows, and 1% of all dividends paid out to shareholders.
As an owner, the investor will also have 1% of the company’s voting rights.
How investors can make money from stocks
Stock investors care about investing in good companies because that means that the stock prices are likely to go up.
They want to buy stocks in companies that have consistent revenue and profit growth, so picking good companies with solid growth potential is essential.
For example, investors who bought and held stocks in companies like Apple or Amazon were rewarded with immense profits as the companies multiplied their revenues and earnings over time, which caused the stock prices to soar.
Fortunately, it is very easy to buy stocks these days. They can be bought online through dozens of different brokers that make investing simple for regular investors.
However, many stock investors these days don’t even buy individual stocks. Instead, they invest in ETFs or mutual funds that hold a basket of different stocks.
For example, funds that hold all the companies in the S&P500 index are very popular. These funds have historically provided excellent returns.
Both stocks and funds can return money to investors through dividend payments, which are usually paid out quarterly.
However, unlike bonds, the dividends are not guaranteed and can be increased, decreased, or even cut entirely if the company feels that it needs to preserve cash.
Besides, not all profitable companies pay a dividend, especially those who are growing quickly. A solid dividend payment is more common among mature companies that don’t have a lot of options for investing in growth.
Companies sell their shares to raise money
Same as with bonds, companies issue stocks to raise money from investors. When a company’s stock is sold on a stock exchange for the first time, it happens through a process called initial public offering (IPO).
For example, some recent high-profile IPOs include Spotify and Uber. When these companies did their IPOs, they received billions of dollars from the thousands of investors who bought the company’s shares.
In an IPO, a company is basically selling a part of itself for cash. After the IPO, investors and traders can then buy and sell the company’s shares on the stock market.
In the US, the two primary stock exchanges are the New York Stock Exchange (NYSE) and Nasdaq. Both of them are accessible through various online brokerage companies.
Bonds represent debt, meaning that you are owed money
Bonds are financial instruments that state that some entity owes you money, along with regular interest payments. Bonds are often called credit, debt, or fixed-income securities.
When you buy a newly issued bond, you are effectively lending money to an entity, such as a company (corporate bond) or the government (treasury bond).
If you buy a bond from another investor, then you are taking over the ownership of the loan that someone else provided.
A company that issues (sells) a bond to investors is effectively getting a loan, just like an individual might get a loan from a bank to buy a house.
How investors can make money from bonds
Bonds have a principal called the par value, which is to be paid in full to the investor on the date that the bond expires, called the maturity date.
Between issuance and maturity, the bondholder receives regular interest payments. The interest rate is termed the coupon of the bond, expressed as a percentage yield.
Bonds can pay interest annually, twice a year, quarterly, or even monthly. There are also so-called zero-coupon bonds, which pay no interest at all. Bonds issued by the US government (termed treasuries) pay interest twice per year.
For example, a 10-year treasury bond might have a par value of $10,000 and a 2% coupon.
This means that an investor who buys the bond will receive $100 interest payments two times per year ($200 per year), and then receive the full $10,000 payment after ten years.
As long as the bond’s coupon is higher than inflation during the lifetime of the bond, then an investor who holds the bond until maturity will make a profit.
How bonds are traded
Unlike stocks, bonds generally do not trade on a centralized exchange. They are traded “over the counter,” which makes buying and selling them slightly more complicated than buying and selling stocks.
Most regular investors don’t buy individual bonds but instead invest in bond ETFs and mutual funds.
However, many brokers available to regular investors do make it possible to buy and sell individual bonds through their online trading platforms.
Some bonds can be risky
Credit rating agencies like Moody’s, Fitch Ratings, and Standard and Poor’s give bonds a credit rating that indicates how risky it is to invest in them.
Like stocks, bonds can have a wide range of risk and return profiles. Generally speaking, the safer the bond is considered, the lower the interest rate will be.
On one end, there are investment-grade bonds that are considered safe but tend to have low yields.
On the other end, there are high-yield bonds, often termed junk bonds. These are muck riskier because the borrower is considered to have a higher risk of being unable to pay its debts.
Some professional investors can make big profits from buying distressed bonds, but this is a high-risk strategy that is not appropriate for most regular investors.
The biggest risk with investment-grade bonds is inflation and interest rates. If inflation increases, then the par value of the bond will have less purchasing power in the future.
If interest rates go up, then the value of the bond also goes down because other investors are then willing to pay less for it.
Bonds are generally safer, but stocks tend to be more profitable
From the perspective of an investor, the most important differences between stocks and bonds have to do with risk and reward.
What most investors want is to get as much reward (profits) as possible, while minimizing risks.
Bonds are generally considered much safer than stocks, but stocks have historically provided much better long-term returns. Bonds are low-risk but low-reward, while stocks are high-risk but often high-reward.
These days, US treasuries only have very low yields of 0-1.3%. In comparison, the US stock market has returned close to 10% per year historically (although there is no guarantee that this will continue indefinitely).
Stock prices tend to be highly volatile, and stock investors often lose (or gain) a significant percentage of their net worth within a matter of days (or even hours).
Many investors are unable to tolerate the volatility and end up buying or selling at the wrong times. But those who buy and hold stocks for many decades usually end up making money.
Unlike stocks, the prices of investment-grade bonds tend to be very stable. The prices mostly move based on inflation and interest rates.
However, the prices of riskier junk bonds can swing wildly based on the perceived risk of the borrower defaulting on its debts. So it is definitely not true that bond prices are always stable.
So even though bonds are generally safer than stocks, there are exceptions to this. Some stocks can be considered safe, while some bonds can be risky.
A summary of the differences between stocks and bonds
The biggest similarity between stocks and bonds is that both of them are financial securities sold to investors to raise money.
With stocks, the company sells a part of itself in exchange for cash. With bonds, the entity gets a loan from the investor and pays it back with interest.
However, from the perspective of the investor, stocks and bonds are completely different. Here is a summary of the biggest differences between them:
- Stocks are risky and volatile but can provide high long-term returns. Bonds tend to be low-risk and low-reward, with some exceptions.
- Stocks represent ownership in a company, while bonds represent debt.
- Stocks provide the owner with voting rights in a company, while bondholders have no voting rights.
- Virtually all bonds pay regular interest, while not all stocks pay a dividend. Bond interest is guaranteed, while dividends are not.
- Most stocks are traded on a stock exchange, while most bonds trade over-the-counter.
- In the case of bankruptcy, bondholders have a higher claim on the company’s assets and are more likely to get some of their money back.
There is also an asset class called preferred stock, as opposed to common stock, which is what is usually referred to as “stocks.” Preferred stocks are like a hybrid between stocks and bonds.
Preferred stocks usually pay a higher dividend and are less volatile than common stocks, but they don’t provide voting rights and the stock price does not increase as much if the company does well.
Owners of preferred stock also have a higher claim on the company’s assets than common shareholders if the company goes bankrupt.
Should you be investing in stocks or bonds?
It is common for investors to invest in both stocks and bonds.
For example, allocating 60% to stocks and 40% to bonds (a 60/40 portfolio) has historically been very popular. This portfolio allocation has had 40% less volatility than a 100% stock portfolio, but with 80% of the returns.
Stocks and bonds are often inversely correlated, meaning that when stocks go down, bonds go up.
These mixed stock and bond portfolios are usually rebalanced regularly, such as once per quarter or once per year.
If you rebalance during a recession or bear market, then you might be selling your bonds at a high price and buying stocks at a low price.
Here are some things to consider when deciding whether to invest in stocks or bonds, or how much to allocate to either asset class:
- Risk tolerance: If you can handle the volatility and drawdowns, then stocks have historically performed better.
- Time horizon: If you plan to hold for ten years or more, then stocks are likely to be more profitable. But if you need the money soon, then short-term bonds are a smarter option.
- Age: Younger investors can have a higher percentage of their portfolio in stocks, but it is recommended to switch to a higher percentage of bonds closer to retirement.
For example, a young person who is saving for retirement might choose to have 90% or 100% of their money in stocks in order to maximize returns.
But someone close to retirement might have 90-100% in bonds because they are going to need access to this money soon and might not tolerate a big market drawdown.
For example, stocks going down 50% could be devastating for someone who depends on this money during retirement.
There are even strategic investment funds that change your portfolio allocation depending on your age and when you plan to retire. Popular examples include Vanguard’s Target Retirement Funds.
Whatever you choose to invest in, make sure to do plenty of research first. Both stocks and bonds can be good investments under the right market conditions.