Stocks vs. Bonds: What Are the Differences and What To Know
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?
A stock is, essentially, a small unit of ownership (think share) in a company. Stocks are usually bought and sold on an exchange, like the New York Stock Exchange.
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.
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.
If you own a stock and the stock price goes up, you can sell your shares for a profit via stock exchanges. You would think that this happens because the company is making money. 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 markets 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.
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 and probably won’t pay dividends.
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.
What Is a Bond?
Bonds are basically loans issued to borrowers like governments or corporations. 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. Investing in a company’s debt can vary widely 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 date, 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 price increases.
Bonds are generally safer than stocks. But again, that’s an oversimplification. Like stocks, bonds also run the risk gamut.
U.S. Treasury bonds are backed by the federal government, so you’re essentially guaranteed to get paid back. The downside of Treasury securities 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: In credit markets, lenders demand higher interest payments when there’s a higher risk.
Just as with stocks, investing in any single bond can be a dangerous investment strategy. Investing in a bond mutual fund, which works pretty much like a stock market index fund, helps you achieve a diversified portfolio.
Stocks vs. Bonds: Risk and Return
Stocks have the potential for both bigger gains and bigger losses than bonds. Between the two, stocks are the riskier investment, but that risk can pay off in a big way. Bonds are safer and less risky, but the returns are fixed and almost always much lower than what you could get with the same investment in stocks. Picking one over the other really depends on how much you can afford to lose if the investment goes south (or how much time you have to recover potential losses).
5 Differences Between Stocks and Bonds
Now that we’ve covered the basics of stocks and 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 price can 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 and regular interest payments, rather than big returns, are typically the reasons you invest in bonds.
2. Corporations and governments issue bonds, but only corporations issue stocks.
Both corporations and governments use the bond market 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 cash 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.
Because stock prices swing up and down, a good investment strategy is to start out by investing mostly in stocks. Then you shift more money into safer asset classes like bonds as you get older.
4. Shareholders get paid after bondholders if a company files for bankruptcy.
When you own equity securities in a company that goes bankrupt, you have to take your place in line with other creditors waiting to be compensated. Secured creditors, like a bank that holds a mortgage, get paid first if a corporation files for bankruptcy.
Once all those claims have been paid, bondholders come next in line. Next comes those who own preferred stock, which is a type of security that has features of both stocks and bonds. Owners of common stock come dead last in line. There’s often nothing left for common 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.
When interest rates rise, bonds tend to drop in price. The reason is that rising interest rates allow bond investors to earn more money. So the price of an existing bond that pays a lower interest rate will drop because investors can earn more money elsewhere.
Bonds vs. Stocks: What’s the Right Mix?
A good investment strategy is 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.
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 and bonds as you get closer to retirement. Another option is to use a robo-advisor to select the best mix of assets based on your age, retirement goals and risk tolerance.
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% stock investments 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.
Frequently Asked Questions (FAQs) About Stocks and Bonds
The difference between stocks and bonds can be a mystery to new investors. We’ve answered some of the mostly commonly asked questions about them so that you can make a wise decision.
Stocks and bonds are both types of investments, but that’s where the similarities end. Stocks are ownership stakes in a company, while bonds are a loan to a company or government entity. Of the two, stocks are the high-risk, high-reward investments, while bonds are more secure, but lack the potential for a big payoff. Instead, they pay fixed interest over time.
Somewhat. Bonds are considered the safer alternative because there’s less chance of losing money — generally, the company has to actually go bankrupt for you to lose money on a bond. However, over long periods of time, stocks tend to outperform bonds as market fluctuations even out.
Yes. There are several ways bonds can lose money:
- Rising interest rates. Bond prices have an inverse relationship to interest rates—as rates rise, bond prices generally fall.
- Inflation. Bonds usually have low yields, and high inflation levels can easily surpass them, eating into profit.
- The company defaults on credit payments. Since bonds are loans, if the company or government can make the payments, the bond can take a hit. If the company dissolves, the bond may become worthless.
This is highly dependent on your individual situation but, in general, no. If it looks like the market is slowing down, it can seem like a good idea (to reduce risk), but generally a 401(k) is a long-term account, and markets can go through a number of ups and downs over a lifetime. And besides, fund management companies are usually making these decisions for investors.
Robin Hartill is a certified financial planner and a senior writer at The Penny Hoarder. Send your tricky money questions to [email protected] or chat with her in The Penny Hoarder Community. Contributor Dave Schafer updated this report.