Table of Contents
- Introduction
- What is a Stock?
- What is a Bond?
- Key Differences Between Stocks and Bonds
- Risks and Rewards of Stocks vs. Bonds
- How to Decide Between Stocks and Bonds
- Frequently Asked Questions
- Key Takeaways
Introduction
When building an investment portfolio, two of the most common assets investors consider are stocks and bonds. Both can play important roles in a diversified portfolio, but they have some key differences that investors should understand before putting their money into them. This article will examine what stocks and bonds are, their key differences, risks and rewards, and things to consider when deciding which - or both - may be right for your investment goals and risk tolerance.
What is a Stock?
A stock (also known as equity) represents ownership in a company. When you purchase a company's stock, you buy a small piece of that company. Stocks are traded on public exchanges like the New York Stock Exchange (NYSE) and Nasdaq.
Some key things to know about stocks:
- The value of a stock is tied directly to the company's financial performance. If the company performs well, the stock value will likely increase. If the company underperforms, the stock value will likely decrease.
- Stockholders can vote on key corporate actions, like electing the company's board of directors.
- Stockholders may receive dividends - regular payouts of company profits. However, bonuses are not guaranteed, like interest payments on bonds (more below).
- Traditionally, stocks are considered riskier investments but have the potential for higher long-term returns compared to other assets like bonds.
- Well-known examples of stores include Apple, Microsoft, and Tesla.
What is a Bond?
A bond is a fixed-income instrument that represents a loan made by an investor to a borrower (typically a company or government). When you purchase a bond, you are lending money to the bond issuer in exchange for regular interest payments and the return on the original investment (principal) at a specified maturity date.
Some key things to know about bonds:
- Bondholders receive predictable coupon payments (interest) at a fixed rate over the bond's life.
- At maturity, bondholders get back their original principal investment.
- Bonds are issued by corporations as well as federal, state, and local governments to raise capital.
- Bonds are considered less risky than stocks but have lower long-term return potential.
- Well-known examples of bonds are U.S. Treasuries issued by the federal government and municipal bonds issued by cities and states.
- Companies issue corporate bonds, which have a higher risk than government bonds.
Key Differences Between Stocks and Bonds
While stocks and bonds can both be part of a diversified portfolio, there are some major differences between investing in these two asset classes:
Ownership and Legal Rights
Stockholders are owners who have voting rights in the company. Bondholders are creditors owed a debt by the issuer and have a higher priority to be repaid if the issuer goes bankrupt.
Potential Returns
Stocks have higher long-term return potential than bonds. However, they come with higher volatility and increased short-term risk.
Payments Received
Stockholders may receive dividend payments, but dividends can vary or be eliminated. Bondholders receive regular, fixed interest payments for the life of the bond.
Issuers
Governments and corporations issue bonds. Corporations issue stocks.
Risk Profile
Bonds carry lower risk than stocks. However, corporate bonds have a higher risk than government bonds.
Price Fluctuations
Bond prices are relatively stable compared to much higher volatility and price swings with stocks.
Liquidity
Stocks trade more frequently on exchanges, usually more liquid than bonds.
Risks and Rewards of Stocks vs. Bonds
Stocks
Risks
- Prices are volatile and can drastically decline in value, especially in the short term. Individual companies can go bankrupt, wiping out your investment.
- Dividends can be reduced or eliminated at any time.
- Returns are unpredictable year-to-year.
Rewards
- Historically, stocks have outperformed most asset classes over the long run, giving investors higher total returns.
- Dividends provide income and the potential for reinvestment and compound growth.
- Owning stock gives you voting rights and a stake in the company as an owner.
Bonds
Risks
- There is interest rate risk - as rates rise, bond prices fall to remain competitive.
- Inflation can reduce the purchasing power of fixed-interest payments.
- Default risk is based on the issuer's creditworthiness, especially for corporate bonds.
Rewards
- Bonds provide fixed, regular income through interest payments.
- Bonds guarantee the return on your original principal investment if held to maturity.
- Bonds provide stability and lower volatility compared to stock prices.
- Government bonds in stable countries are considered among the safest investments.
How to Decide Between Stocks and Bonds
Choosing between stocks and bonds depends on your financial situation and investing goals. Here are some things to consider:
- Time Horizon - Stocks are better to ride out volatility for longer periods, while bonds are suitable for shorter-term purposes.
- Risk Tolerance - Your ability to stomach declines in value and overall volatility should determine your mix of stocks and bonds. Conservative investors favor more bonds.
- Income Needs - Bonds and dividend stocks can provide regular income. Growth stocks focus on capital appreciation over dividends.
- Diversification - Combining stocks and bonds allows you to gain the benefits of each asset class while reducing overall portfolio risk.
- Tax Implications - Interest on bonds is taxed at ordinary income rates. Qualified stock dividends are taxed at lower long-term capital gains rates.
- Economic Outlook - When the economy is expanding, stocks tend to outperform. In recessions, bonds are less volatile.
- Personal Situation - Age, life stage, job security, and family circumstances should factor into determining your optimal asset allocation.
Frequently Asked Questions
Are stocks riskier than bonds?
Yes, stocks are considered riskier overall than bonds. Individual stock prices are more volatile than bond prices. Certain types of bonds, like those issued by stable governments, are extremely low risk.
Can stocks have fixed dividend payments like bonds have set interest?
No, stock dividends are variable and determined by a company's board of directors. They can be cut or eliminated at any time. Bond interest is fixed for the life of the bond at issuance.
What stock vs. bond mix is typical for an investment portfolio?
A typical starting mix is 60% stocks and 40% bonds, adjusting the allocation over time depending on your risk tolerance, time horizon, and investment goals. More conservative portfolios shift to a higher percentage of bonds.
What causes bond prices to change?
Bond prices move opposite to interest rates - rising rates mean falling bond prices, and vice versa. Longer-term bonds are more sensitive to rate changes. The credit quality of the issuer also impacts the price.
How risky are corporate bonds compared to stocks?
Corporate bonds carry more risk than government bonds but less risk than stocks. Default risk is based on the financial strength of the issuer. Stock prices are more volatile than high-quality corporate bond prices.
Can I lose my original investment in a bond if I hold it to maturity?
If held to maturity, you can get your original principal investment back unless the issuer defaults. Stocks have no such guarantees, exposing shareholders to potentially significant losses.
Which has performed better historically - stocks or bonds?
Over the past century, stocks have returned an average of about 10% annually. Long-term government bonds have averaged around 6%, corporate bonds 7%. However, stores have significant volatility from year to year.
Key Takeaways
- Stocks represent ownership shares in a company, while bonds are loans made to an issuer in exchange for fixed interest payments.
- Stock prices are highly volatile compared to the relatively stable prices of bonds.
- Bonds provide regular income, while stocks offer higher long-term growth potential and dividends.
- Stocks involve higher risks but also higher potential rewards compared to lower-risk bonds.
- A diversified portfolio should typically include a mix of stocks and bonds balanced to your investment objectives, time horizon, and risk tolerance.
- Many factors like taxes, economic conditions, income needs, and personal circumstances must be considered when deciding between stocks, bonds, or both.
