You’ve probably heard the terms stocks and bonds bandied around before, but what are they exactly? Put simply, stocks and bonds are two types of investments that can be included in an investment portfolio. You make an investment in stocks or bonds hoping to earn a return, meaning that over time you’ll have more money than you paid in. But stocks and bonds are two very different things that serve different purposes in a diversified investment portfolio.
WHAT ARE STOCKS?
Stocks are investments directly in companies. When you buy a company’s stock, you’re buying a share of that company. You literally own a piece of the business. That means that as the value of the business increases, your share of that value goes up. Conversely, if the value declines, the value of your stock will go down. If the business makes a big profit and decides to give some of that money to its owners, you’ll get a check (usually called a dividend).
WHAT ARE BONDS?
Bonds are an investment in debt. Think about it this way: When you borrow money to buy a home, someone (usually a bank) is loaning you that money and you’re going to pay it back with interest. A bond is a way that the government or businesses take loans. You give them the money they need (usually just a portion of it) and over time they will pay you back with interest. You could hold on to the bond and get your money back over time or you could sell it early to someone else.
If you’re looking for the chance to earn a higher return, you’ll probably want to consider stocks. But with the potential of more return comes more risk.
THE DIFFERENCE BETWEEN STOCKS AND BONDS
Investment grade bonds, or bonds that have a relatively low risk of default, are usually considered safer investments. Say you buy $1,000 in bonds from a major corporation. The company agrees to pay you four percent yearly interest over 10 years. Unless the company goes bankrupt or runs into serious financial trouble, it’s likely that you will receive exactly what the company promised and walk away with $1,400 ten years later. But because bonds tend to be safer, you won’t have the opportunity to reap a high return as you would with stocks.
If you’re looking for the chance to earn a higher return, you’ll probably want to consider stocks. But with the potential of more return comes more risk. Say you bought $1,000 worth of stock in a small tech company that sells products online (let’s call it Rainforest). Over the next 15 years, Rainforest becomes a household name that does billions of dollars worth of business each year. The value of its stock increased 100 times. You could sell your stock and walk away with $100,000. (Uncle Sam will want a cut of this — but even after that, it’s a pretty good return.) However, it’s also possible that the stock price could drop below what you paid. Or that the company you invest in will go bankrupt in a year and you’ll walk away with nothing.
Ultimately, the best investing strategies use a mix of stocks and bonds (and sometimes alternatives like cash, commodities or real estate) to balance risk and opportunity for reward. And you don’t have to invest directly in individual stocks and bonds. You can also buy funds like mutual funds or exchange-traded funds that invest money in a wide variety of stocks, bonds and alternatives for you.