May 26, 2023
Bonds vs. Stocks: What’s the Difference?
Bonds and stocks are two of the most common investment options with distinct characteristics. Stocks represent ownership in a company, while bonds involve lending money to the issuer. Typically, stocks and bonds have had opposite performance trends, meaning when stock prices increase, bond prices often decrease, and vice versa. These differences make both assets play an important role in diversifying your investment portfolio.
|Money is made through predictable interest payments||Money is made when the stock price increases and through dividends|
|Relatively lower-risk compared to stocks||Generally riskier than bonds|
|Usually have lower growth potential than stocks||Significantly more growth potential than bonds|
|Generally subject to income tax||Usually subject to capital gains tax|
In this article, we’ll cover:
What is a bond?
Corporations and governments issue bonds to raise money. By buying a bond, you’re essentially loaning the issuer the sum of money you’re investing, and they’re agreeing to pay you interest periodically, as well as the face value of your loan when the bond reaches maturity. The maturity date, or length of time the issuer holds your principal, varies widely among different types of bonds; some even mature in less than a year, making them appealing to people looking for short-term investments.
Investors can purchase bonds through a brokerage, investment bank, or, in the case of government bonds, directly from the U.S. government. They can be an attractive investment because of their relatively low risk and because they provide a predictable income stream.
Types of Bonds
Different types of bonds come with varying levels of risk, expected returns, maturity, and tax considerations. Broadly, there are three types of bonds to consider: U.S. government, corporate, and municipal bonds.
- U.S. government bonds: A government bond is issued by the federal government and is usually considered a low-risk investment because it is government backed. While these are generally the lowest-risk bond investments, they tend to offer lower rates of return, and the fixed interest rates may risk falling behind rising inflation. They are considered at low risk of default and are usually tax advantageous because they are typically exempt from state and local tax. The ten-year Treasury bond is one of the most common examples of this type of bond.
- Municipal bonds: A state or other municipality issues a municipal bond. These are seen as having somewhat higher risk compared to government bonds but are considered safer than corporate bonds. While yields are often lower than corporate bonds, interest from these bonds is often free from federal income tax, as well as from state tax in the state where they’re issued
- Corporate bonds: A corporate bond is issued by a corporation. These bonds typically offer higher yields, but the interest you earn is subject to taxes, and they are at higher risk of default than government bonds, as a company could declare bankruptcy. If the company defaults on the bond, you could lose both interest and your principal investment.
Pros and cons of investing in bonds
Bonds can be one element of a diversified investment portfolio, and like all investments, they come with distinct advantages and disadvantages.
- Fixed returns: Before investing, you can know exactly what your return will be based on the bond’s fixed interest rate. You’ll generally receive interest rates periodically, and your full principal is returned when the bond matures.
- Lower risk: The return you receive on your investment is in the form of interest, not directly tied to a company’s share price, so bonds are less subject to the risks of market volatility. In the event a company has to liquidate, bondholders are paid before shareholders. Of the three types of bonds, government-issued bonds are considered the lowest risk for default.
- Less volatile: Bonds with a longer maturity are sensitive to changes in interest rates and inflation because they affect the real rate of return, or how much the face value and interest are actually worth. Despite this impact, bond values are still generally more stable than stock values.
- Lower returns: Historically, bonds have seen lower returns than stocks. While investors see fixed returns, making earnings more predictable, the growth potential is usually more limited than investments in stocks.
- Limited liquidity: Liquidity refers to how quickly you can get your hands on your cash. Some bonds are more liquid than others, but, unlike most stock investments, your investment can get locked in for a number of years without easy access to that money.
- Interest rate risk: Bonds are more directly impacted by changes in interest rates, which means their value and price can fluctuate as interest rates rise and fall. Interest rates and bonds generally have an inverse relationship, referred to as interest rate risk. When rates go up, bond prices go down, and when rates decline, bond prices typically rise.
What is a stock?
A stock is an equity representing ownership, or shares, of a company, making the investor a shareholder and entitling them to a portion of that company’s profits. Public companies sell their stock through a stock market exchange to raise money for their business. Investors buy those stocks through a brokerage. They can make money when the stock price increases and they sell at a profit, or through dividends if a stock pays dividends. While stocks are considered riskier than bonds, they have a higher earning potential.
Types of stocks
Stocks are categorized in several ways. This includes the stock type, the company’s size, and specific stock characteristics. While these categories help group stocks by common characteristics, stocks in the same category don’t necessarily share any other significant characteristics, risks, or performance expectations.
- Common stock: Most stocks are common stocks. These represent partial ownership of a company and may or may not offer dividends. If a company fails without having assets left over, investors lose their investment.
- Preferred stock: Preferred stocks give shareholders a preference over investors who own common stock. While they don’t have voting rights in a company, these investors receive dividend payments before common shareholders do and get back a certain amount of money if the company dissolves. Not all companies offer preferred stocks.
- Large-cap stock: These companies have a market capitalization value of more than $10 billion. Large-cap stocks are a significant portion of the U.S. equity market and are often core portfolio holdings. These tend to be more stable investments than mid-and small-cap companies but do not always offer the same growth opportunities.
- Mid-cap stock: Mid-cap stocks have a market capitalization value between $2 billion and $10 billion. These companies offer growth potential and are considered less risky than small-cap stocks.
- Small-cap stock: A small-cap stock’s market capitalization value is generally between $250 million and $2 billion. These companies are usually growing fast but are seen as more volatile and risky than the more stable mid- and-large cap stocks.
- Growth stock: A growth stock is a share in a company that is expected to grow at a rate significantly above the market’s average growth. Because these companies are reinvesting in their growth, they generally do not pay dividends. Growth stocks are also considered more prone to volatility in share price.
- Value stock: An inverse of a growth stock, a value stock has the potential of selling at a higher price but is currently trading at a lower price than its actual worth based on its earnings, dividends, or sales. Value stocks are typically less volatile and more stable than growth stocks, making them relatively less risky.
Pros and cons of investing in stocks
Those investing in stocks are investing in a company’s potential, which comes with varying degrees of risk and possible returns. Whereas a bond generally has fixed returns, the stock market can be much harder to predict.
- Potential for higher returns: Investors have the potential to get a much higher return with stocks than bonds in the form of both dividends and increases in stock values.
- Liquidity: Investors can sell their stock anytime, meaning it’s easy to take money back out of the market if you need it. Note that if the timing isn’t ideal, you risk taking the money out of the market at a loss.
- Staying ahead of inflation: Money held in the S&P 500 has had an annualized stock market return of around 10% over the long haul, which is historically a higher rate than inflation.
- Time: Investing can be time-consuming, as it requires research, monitoring the market, and time-in-market to see returns. Compounding returns may take years or decades to see. Unlike bonds, you can’t predict at the outset when you will see a return on your investment.
- Risk: Returns are not guaranteed. It is always possible that a company does poorly and stock prices drop significantly. And there’s no guarantee stocks that drop in price will recover their value, so you may wind up selling them at a loss. stocks, you’ll experience a loss. If you can’t afford to lose your initial investment, purchasing bonds gives you a higher likelihood of hanging on to your principal compared to stocks.
- Volatility: Stock prices can rise and fall dramatically. This volatility means that the value of your stocks could drop, sometimes dramatically and unexpectedly. Volatility can also be hard for investors who feel stressed when watching their investments rise and fall dramatically, and may cause them to make emotional selling decisions.
Bonds vs. stocks
Stocks and bonds often form the building blocks of a diversified investment strategy. They perform differently under different market conditions, have distinct tax implications, and have different risks and returns. Where stocks can be riskier with higher returns, bonds are generally more stable with more predictable returns.
|Ownership||Bondholders are not shareholders and do not have ownership in a company||Owning stock in a company makes you a shareholder and partial owner of a company|
|Liquidity||Limited liquidity, as you often can’t access principal until maturity||A stock is a liquid investment that can be sold at any time|
|Price||Priced based on contractual cash-flows and interest rate risk||Determined by supply and demand|
|Returns||Returns come in the form of predictable interest payments and tend to be lower than stocks||Returns come in the form of rising stock prices or dividends and tend to be higher than bonds|
|Taxes||Generally subject to income tax, but some bond types are tax-advantaged||Earnings are usually subject to capital gains tax, which may be lower than your income tax rate|
|Risks||Considered lower risk than stocks||Considered higher risk than bonds|
Bonds and stocks in your investment portfolio
It doesn’t always come down to choosing between bonds vs. stocks in your portfolio. If you’re following a diversified investment strategy, you may wish to own both types of investments, in which case you’ll want to consider what percentage of bonds and stocks to hold. Owning both is considered part of a because it spreads the risk of poor performance across investments.
Your age, time horizon, risk tolerance, investment objectives, and available money will impact how you diversify your portfolio. Often investors choose to invest in higher-risk investments with higher possible returns when they’re young, which could mean holding more stocks than bonds. On the other hand, many investors gradually reduce their risk as they approach retirement in order to focus on asset preservation more than growth, in which case having a more significant percentage of your portfolio dedicated to bonds may make sense. Your specific diversification strategy will depend on your unique situation and goals.
Stocks vs. bonds in your investment strategy
Diversification is one of the pillars of the Stash Way, and both stocks and bonds are core components of this investment strategy. While it is not a guarantee of success, spreading your portfolio across diverse assets that behave differently in the market and have different volatility can reduce your vulnerability to the risks associated with any single asset.
Stocks and bonds are core components of a diversified investment strategy that can help you achieve your long-term financial goals. Determining what percentage of that portfolio you want to invest in bonds vs. stocks is up to you.
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