Stocks and bonds are both common investment instruments, and each come with their own investing nuances. How much you should invest in either of these asset classes depends upon many factors—your age, goals, risk tolerance, and the amount of capital you have to work with.
When you begin investing, you should work to understand the different roles that stocks and bonds play in your portfolio beyond just generating income or growth. It is important to familiarize yourself with each type—and some different strategies you can use—so that you can make more informed decisions for your financial goals.
How Stocks and Bonds Are Different
A share of stock represents ownership in a business. For example, if you own a sandwich cart and divide it into ten pieces, each of those pieces (shares) is entitled to a 1/10 cut of the profits or losses. If the business is publicly owned, those 10 shares are bought and sold on the stock market. If you own all 10 shares, you own 100% of the enterprise.
The stock market is similar to a real-time auction where existing and potential owners bid to buy equity (ownership) in publicly traded companies, such as the sandwich cart.
There is a common misconception that bonds are safer than stocks—it is more accurate to say that stocks and bonds face different risks and respond differently to market swings.
A bond represents a loan made by the bond purchaser to the bond issuer. Sovereign bonds are issued by nations, municipal bonds are issued by municipalities, and corporate bonds are issued by corporations.
Using the sandwich cart as a simplified example, if you issued a $10,000 fixed income bond to an investor at a coupon rate of 4%, you would receive the money from them and owe them 4% of the face value of the bond per year. You set a date for the bond to mature, at which time you return the principle to the investor.
Bonds can then be traded by investors on the secondary market—the prices they are willing to pay will vary on prevailing interest rates. Put into simple terms, if rates rise, prices on existing bonds generally fall. The opposite is true if rates fall—existing bond prices rise because there will be more demand for the higher-rate bonds.
Stocks are notoriously volatile. With investors bidding for them, and profit not being assured, greed and fear can sometimes overwhelm the market. Perfectly fine enterprises have been basically given away during a market and economic downturn, selling for far less than what they should have been worth.
At opposite end of the spectrum, you get periods during which non-profitable businesses trade at obscenely high valuations, completely detached from their real value. An example of this is in 1999 when the dotcom bubble was fully inflated—investors were irrationally exuberant in their expectations of the future returns of internet-based companies. When the realization sank in that these companies were over-valued, the bubble burst, causing the market to crash.
A good strategy for avoiding an investment bubble and the burst that follows is to stay away from the trending investments at any given time. Many traders and investors have lost large sums by following trends.
Making stocks even more complicated, a business that has made generations of people wealthy, such as The Hershey Company, can suffer a period of loss—such as the years 2005-2009 when their stock slowly lost 55% of its market value despite an increase in earnings and dividends.
Bonds are typically less volatile than stocks, though bonds can experience extreme fluctuations in price as evidenced by the 2007–2009 market meltdown—investment banks were declaring bankruptcy and trying to raise cash in any way possible after the housing bubble burst. These banks dumped huge quantities of fixed income securities on the market, driving down prices.
A few types of bonds have built-in protection against volatility, such as the Series EE savings bonds, which can be redeemed for their present value, including any early redemption interest penalty you may trigger, regardless of market conditions.
A business's ability to repay it's interest liabilities is generally measured by its interest coverage ratio (earnings before taxes and interest divided by interest expenses). If the bond issuer has a good interest coverage ratio and can pay the bond's principal when it is due, the major risk of investing in bonds is the fact that they represent a promise of future repayment in fixed, nominal currency. In other words, when you buy a long-term bond, the risk you take is that purchasing power will drop dramatically in the long-run.
For instance, a $10,000 long-term bond could give back your $10,000 when it matures, but it may not be valued the same as when you gave them (money loses value over time due to inflation). You might not even recoup the inflation loss through coupon payments. Also, your returns could be less than they would have been if you had invested in stocks.
Stabilizing Your Portfolio
Used together, stocks and bonds can balance out the volatility in a portfolio. By combining the two in a calculated manner, it is likely that you can reduce the risks of each and have a strengthened defense against the unexpected arrival of a recession or depression.
A common strategy to mitigate risk is for an investor to subtract their age from 100, and use that result for the percentage of stocks in their portfolio with the rest invested in bonds. As you age, you transfer stocks to bonds based on the 100 minus your age strategy.
There are many other strategies you can use to allocate assets in your portfolio. Vanguard has a list of the allocation strategies they use depending on investor goals. Investors can choose between income, balanced, and growth-based portfolio allocations.
The exact same stocks and bonds, in the exact same proportions and tax brackets, can lead to wildly different net worth outcomes based on the structures in which those securities are held.
Placement of Assets Is Important
In addition to allocation, it's important when selecting your mix of stocks and bonds that you divide your portfolio based on a tax management strategy. Taxes can take a large portion of your capital from you if you do not have your assets placed in accounts that have tax-advantages for different types of assets.
For example, if you had bonds with a high taxable interest income and non-dividend paying stocks in your portfolio, you'd be taxed at almost double the rate of cash dividends. You could place your high-yield bonds into a SIMPLE IRA, and hold stocks that don't pay dividends in a taxable brokerage account—this allows you to defer taxes from high-yield dividends and pay the lower capital gains tax on your stocks if you sell them.