- Stocks and bonds are both part of a healthy investing portfolio
- Stocks represent partial ownership of a company, and rise and fall with said company
- Bonds are a loan agreement, with set terms for the length of the loan and interest payments
Stocks and bonds are possibly the most common terms people use to describe investing.
And fair enough, as they are both crucial to any investor’s portfolio.
Think of an investment portfolio like a garden of flowers—if you have just roses and a rose-killing insect arrives, you lose your entire garden.
If you plant tulips, sunflowers, and roses, you’d still have two-thirds of your garden when those insects show up.
It’s important to understand exactly what both stocks and bonds are, what they can do for your investment strategy, and why it’s a good idea to have some of each in your investment garden.
What’s the difference between stocks and bonds?
Stock amounts to a piece of ownership in a company. (You may also hear stocks referred to as equity or shares.)
(You may also hear stocks referred to as equity or shares.)
If someone says they own 500 shares of Facebook, they mean they own 500 very small pieces of Facebook. Companies issue stock to the public and that stock trades between investors on exchanges, like the New York Stock Exchange.
Trading is the term used for buying or selling stock.
Equities can generate returns through capital gains or dividends. However, there is not a defined holding period or a promise of return of capital at the end of that period.
Translation: Stocks are fluid, and they don’t have any guarantee, no matter what your best friend or coworker tells you.
A bond is like a loan.
When you buy a bond, you are lending money to an entity with the promise that you receive that money back, with interest, after a certain amount of time.
The time-period can vary anywhere from one day to ten plus years, and the interest earned will vary bond to bond.
Bonds generate returns through periodic interest payments and with the principal amount returned to the lender at the end of the period.
However, it’s important to note that bond prices may fluctuate during that holding period, and can be sold for a gain or loss prior to your term ending.
Stocks vs. bonds
The biggest difference between stocks and bonds are their risk levels and their return potential.
Speaking very generally, stocks have historically offered higher returns than bonds but come with increased risk. While you may earn more with stocks, you may also stand to lose more.
Bonds may have a lower return rate, but they are also generally less volatile than stocks.
What’s the right mix of stocks vs. bonds for a healthy investment portfolio?
The answer to that depends on an investor’s risk tolerance, timeline, and strategy.
For example, if you’re 25 and saving for retirement that is 40+ years away, you can probably afford to take on more risk (and thus buy more stocks than bonds) than someone who is saving for a down payment on a home in 3 years.
In general, stocks have a higher potential for growth, while bonds provide fixed income via their interest rates.
This is a very broad outline though, as dividend producing stocks can provide income, and bond prices can rise and fall.
You’ve probably heard the refrain ‘diversify your portfolio,’ and it’s excellent investing advice.
Too much of anything can become a bad thing, and it’s essential to have a mix of stocks and bonds in a healthy investment portfolio. Since they each behave differently, a combination of both can provide a more balanced portfolio.
For younger investors, it may be beneficial to hold more stocks and to concentrate on growth.
Having a 40-year timeline until retirement means you have time to make up for market losses, and also gives you a chance to see significant growth earlier in your career.
As you age and get closer to pulling money out of your investments, you may focus less on growth and want the fixed income that bonds can generate.
Risk factors of stocks and bonds
Not all stocks have the same level of risk, and not all bonds are safe from fluctuations.
A common misconception with stocks is that they all have equal levels of risk and that no other vehicle is more risky.
While yes, generally speaking, stocks experience more market variance, high yield and emerging market bonds can carry more risk than some equities.
There is no one magical investment that will never lose money, or one that will always make money.
That’s why a portfolio that has a mix of both is beneficial for your finances.