A stock is an investment in a company. Your investment (purchased in shares) can grow or decline based on the company’s success.
A bond is an investment in a company’s or government’s debt. After you purchase a bond, the entity develops a plan to repay the principal of your investment with interest.
Including a mix of both stocks and bonds in your portfolio is one of the easiest ways to diversify your portfolio.
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 investments 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.
There are many different types of bonds, and bonds can be issued by different entities, including companies (corporate bonds), state and local governments (municipal bonds) or the federal government (Treasury bonds).
How do you make money on stocks and bonds?
The goal of investing money is to have it grow over time. Stocks and bonds can both make money, but in different ways. Let’s take a look at how stocks and bonds work:
How stocks make money
If you’re looking for the chance to earn a higher return, you’ll probably want to consider investing in 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.
Stocks can also make money while you’re still holding the investment. If a company does well, it may distribute dividends—money paid by a company to shareholders. Dividends are typically paid out quarterly if a company’s board of directors decides it can afford to share profits with investors rather than investing them back into the company. This typically happens only with well-established, stable companies that have been around for a while.
How bonds make money
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 have issues making payments 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 as high a 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 fluctuates in the opposite direction of interest rates. So, if you decide to sell a bond prior to the maturity date and interest rates go up, you would have to sell your bond for less (for example, a $1,000 bond might go for $900) because investors can purchase new bonds with higher interest rates. However, if you hold your bond to maturity, it will pull back to the full $1,000 face value.
Shareholder rights vs. bondholder rights
As with any investment, your profit on a stock or bond depends on the performance of the issuing company or entity. However, when a stock or bond performs poorly, the entity’s responsibility to you, the investor, is different for a stock than it is for a bond.
Depending on the type of stock you’ve purchased, you’ll have different rights as the shareholder. If you’ve purchased a common stock (the type most people purchase), you’ll typically have voting rights at shareholder meetings and receive any dividends that are paid out. If a share price rises in value, you, as the shareholder, have the opportunity to sell your shares for a profit. However, if the share prices fall drastically and a company goes into liquidation, shareholders are the last to be repaid. With a preferred stock, however, you’d be repaid before common stockholders (though you don’t typically have any voting rights).
A bondholder’s position is much more secure. Because a bondholder is a creditor, if an entity defaults on its debt, the bondholders will be repaid before any shareholders (even if the entity is able to repay only a portion of the principal).
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How are stocks and bonds taxed?
Most often, income you’ve made on a bond will be subject to income tax. Stocks, on the other hand, are subject to capital gains tax when sold, in addition to income tax on any dividends issued while you held the stock. The amount of capital gains tax can vary based on how long you’ve owned the stock. If you’ve owned the stock for a year or less, you’ll pay short-term capital gains tax. (The short-term capital gains tax rate is typically the same as your income tax rate.) If you’ve owned the stock for longer than a year, you’ll pay long-term capital gains tax at a rate that is typically lower than your income tax rate.
Which is better: bonds or stocks?
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 you stay ahead of inflation. Because stocks carry 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 into 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. However, if you’re further from retirement, you can typically afford a bit more risk with assets like stocks.
Managing an investment portfolio requires time and expertise. Rather than attempting to manage your investments on your own, consider reaching out to a Northwestern Mutual financial advisor who can develop a customized, strategic investment strategy that works with all of your assets and elements of your financial plan.
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; conversely, when interest rates rise, bond prices typically fall. No investment strategy can guarantee a profit or protect against loss.