Knowing These 5 Key Rules About Stocks vs. Bonds Will Make You Richer
In the investment world, stocks are the life of the party. Bonds, quite frankly, are boring.
Even if you’re a set-it-and-forget-it investor, just watching stocks can be thrilling. In the past year, the stock market has brought us wild stories about GameStop, Tesla and newly minted day traders. But who the heck starts a conversation by talking about what the bond market was doing today?
Stocks are certainly the more interesting asset, but in investing, it pays to be at least a little bit boring. Here’s a primer on stocks vs. bonds — and why you need to own both.
What Is a Stock?
When a company wants to fuel its growth, it will often go public. That means its shares become available on the open market for investors like you and me. When you buy stock in a company, you become the owner of a tiny fraction of the company. You make money on stocks in one of two ways:
- The stock’s price goes up and you sell it for a profit. You would think that this happens because the company is profitable. But sometimes a stock’s price will skyrocket even though the issuing company is losing money. Or it will plummet even though the company is doing fine. That’s because stock prices tell us investor predictions, rather than the current reality. Tesla, for example, lost money nearly every quarter from the time it went public in 2010 until 2018, yet its shares still soared 1,340% in that period.
- The stock pays a dividend. Sometimes companies distribute part of their profits to shareholders by paying a dividend. You’re more likely to get a dividend from blue-chip stocks, which are issued by huge corporations with a long history of stable profits. Think the Johnson & Johnsons and Procter and Gambles of the world. A company that’s in startup mode needs to reinvest its profits, so it’s less likely to pay dividends to shareholders.
There’s no limit on how much a corporation can earn, which means that, theoretically, your potential profits on stocks are unlimited as well. You could become a millionaire by picking the next Apple or Amazon. But you could also lose your entire investment if a company goes out of business.
While stocks are often described as a risky investment, that’s an oversimplification. Investing in blue-chip stocks is worlds away from investing in penny stocks, which are usually super cheap because the company behind them is unprofitable or financially troubled. You can reduce your risk further by investing in index funds, which automatically invest you in hundreds or even thousands of companies. That shields you from the risk of any one company failing.
Investing in stocks is typically the way you grow your money and build a nest egg. Even though the stock market can be volatile, you shouldn’t be scared by short-term losses. Long-term growth is what you’re after.
What Is a Bond?
When a government or a corporation needs to finance debt, they’ll often issue bonds. When you invest in bonds, you become a creditor. You get paid as long as the corporation or government doesn’t default on its debt. There are three main types of bonds:
- U.S. Treasurys, which are issued by the federal government. They’re considered the safest investment on the planet, because the risk of the U.S. government defaulting on its debt is essentially zero.
- Municipal bonds, which are issued by state or local governments. They’re a bit riskier than U.S. Treasurys, but still considered a safe investment.
- Corporate bonds, which are issued by corporations. They vary in terms of level of risk. The safest corporate bonds are often referred to as investment-grade bonds. The riskiest ones are known as junk bonds.
Most bonds offer fixed payments called coupons that are typically delivered twice a year. When the bond reaches its maturity, i.e., the end date of the loan, you get paid back for your principal as well.
So if you bought a bond for $10,000 that paid 5% interest for five years, you’d get interest payments of $500 total per year for five years. Then at the end of five years, you’d get your $10,000 back.
Bonds don’t have that kingmaker potential that stocks do. If you bought bonds in the next Apple or Amazon that pay 3% annually, you’ll get 3% annually no matter how much the company profits or how much its share prices increase.
Bonds are generally safer than stocks. But again, that’s an oversimplification. Like stocks, bonds also run the risk gamut.
U.S. Treasurys are backed by the federal government, so you’re essentially guaranteed to get paid back. The downside is that you get extremely low interest payments because you’re barely taking any risk.
A 10-year Treasury note currently yields 1.18%. Your real risk here is that the interest payments won’t keep up with inflation, which is essentially the same as losing money. Your money will buy less and less over time.
Some bonds can be quite risky, though. A junk bond that’s issued by a troubled company, by comparison, can yield 6% or more for the same reason that you’d pay a higher interest rate if your credit score is low: The lender has to be compensated for taking extra risk. Just as with stocks, investing in any single bond can be dangerous. Investing in a bond index fund, which works pretty much like a stock market index fund, helps you achieve a diversified portfolio.
Stocks vs. Bonds Showdown: 5 Key Differences to Know
Now that we’ve covered the basics of stocks vs. bonds, let’s recap five important differences that matter to you as an investor.
1. Stocks offer unlimited potential returns, while bonds offer fixed income.
A stock’s price could technically soar to infinity, so there’s no limit on your potential profits. To make money off stocks, you either have to sell them for a profit or receive a dividend — but returns and dividends are never guaranteed.
The benefit of bonds is that the issuer is contractually obligated to make interest payments. That fixed income is especially valuable if you’re on a retirement budget. Although you could also make money buying and selling bonds, this is risky for most people. Stability, rather than big returns, is typically the reason you invest in bonds.
Realistically, you can expect your annual returns to average around 10% if you invested in S&P 500 index funds.
2. Corporations and governments issue bonds, but only corporations issue stocks.
Both corporations and governments issue bonds to finance debt. Only corporations issue stocks. They do so by going public through an initial public offering, making their shares available in the open market. Usually, companies do this to raise money to fuel their growth.
3. Stocks are more volatile than bonds, meaning their prices fluctuate more.
Still, that shouldn’t worry you if you’re a decade or more away from retirement. Your money has time to recover if the stock market crashes. If you invest across the stock market and keep your money invested for at least a decade, your returns will be positive more than 90% of the time.
4. Shareholders get paid after bondholders if a company files for bankruptcy.
Secured creditors, like a bank that holds a mortgage, have to get paid first if a corporation files for bankruptcy. Once all those claims have been paid, bondholders come next in line. But shareholders come dead last in line. There’s often nothing left for stock investors after bankruptcy.
5. According to conventional wisdom, stock prices and bond prices move in opposite directions.
The thinking is that when the stock market tanks, investors will seek out the safety of bonds, whereas when stocks are soaring, investors will take money out of bonds in pursuit of higher returns. But in recent years, stock and bond prices haven’t always moved inversely. For instance, during the COVID-19 panic in March, both stock and bond prices crashed.
You typically want to start out mostly invested in stocks and shift more money into bonds as you get older. The reason is that when you’re younger with decades left until retirement, you want your money to compound. You also have plenty of time to recover from a stock market crash. But the closer your retirement gets, the more vulnerable you are to a bear market, so you want safer investments.
Bonds vs. Stocks: What’s the Right Mix?
One option for making sure you get your asset allocation right is to invest your retirement savings in a target-date fund. It will gradually rebalance your mix of stocks vs. bonds as you get closer to retirement.
Another option is to use a robo-adviser to select the best mix of assets based on your age, retirement goals and risk tolerance. This is much more likely to be an option if you have a Roth IRA or traditional IRA compared to a 401(k) plan or any other employer-sponsored account.
If you’re determined to DIY your asset allocation, here’s a rule of thumb financial planners often recommend: Your proper stock allocation is 110 minus your age. So if you’re 40, you’d aim to have 70% stocks and 30% bonds.
Regardless of what mix of assets you choose, the important thing is to start investing already. Time is the best weapon you have for making that money grow.
Robin Hartill is a certified financial planner and a senior writer at The Penny Hoarder. She writes the Dear Penny personal finance advice column. Send your tricky money questions to [email protected].