You’ve probably heard the terms stocks and bonds 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 buy a share of the company. You literally own a piece of the business. That means that as the publicly traded 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 receive a dividend.
What are bonds?
Bonds are an investment in debt. Bonds are a way for companies and governments to raise money: they're essentially small loans you make to large entities. For example, if a city wants money for a park, it can sell bonds now and pay buyers back with interest later. You give the city the money it needs (usually just a portion of it) and over time it will pay you back with interest. You could choose to hold on to the bond and get your money back over time or sell it early to someone else.
Stocks vs. Bonds
What are the pros and cons of stocks vs. bonds, and should you invest more in stocks or bonds? Let's look at how each works:
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. Stocks fluctuate along with markets.
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. 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.
Bonds issued by the U.S. federal government and bonds labeled investment-grade are generally stable investments. They pay steady interest over time (also called coupon payments), and the entities are unlikely to go away before the maturity date, or date when the debt plus interest must be paid.
Say you buy $1,000 in bonds from a major corporation. The company agrees to pay you 4 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 10 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.
Unlike stocks, bonds are a debt the company owes to you rather than an investment, so the interest and value of the bond is not tied to the stock market value of the company. The price of bonds also goes in the opposite direction of interest rates. So, if interest rates go up, you will be able to sell your bonds for less (for example a $1000 bond might go for $900) because investors can purchase new bonds with higher interest rates.
How is a bond different from a stock?
Bonds are investments in debt while stocks are a way to purchase part of a company. Stocks and bonds also offer different risk levels and returns on investment. Let's look at the pros and cons of investing in each.
Pros and cons of stocks
Stocks can be high-reward investments given that they have the potential to result in large returns over a long period of time. They tend to grow with the economy and can help stay ahead of inflation. Because stocks are higher risk, it's easier to lose money, especially if you're investing in individual stocks.
Pros and cons of bonds
Overall, bonds tend to be lower-risk investments than stocks and often they offer a higher interest rate than you could get by putting your money in the bank. The drawback is that they are low-reward, and interest payments may only keep up with inflation. They are also often more expensive than stocks, as most bonds are sold in increments of $1,000, so there is a higher barrier to entry. Lower-rated bonds, like junk bonds, run the risk of default.
Investing in stocks and bonds
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.
If you are closer to retirement, you'll typically want a larger percentage of your portfolio in stable assets like bonds. Talk to a financial advisor to make sure you're on track for retirement.
All investments carry some level of risk including the potential loss of principal invested. With fixed income securities, such as bonds, interest rates and bond prices tend to move in opposite directions. When interest rates fall, bond prices typically rise and conversely when interest rates rise, bond prices typically fall. No investment strategy can guarantee a profit or protect against loss.