Investors are always told to diversify their portfolios between stocks and bonds, but what’s the difference between the two? Here's a look at the differences between stocks and bonds at the most basic level.
Stocks Are Ownership Stakes
Stocks and bonds are two different ways for an entity to raise money to fund or expand its operations. Stocks are simply ownership shares of corporations. When a company issues stock, it is selling a piece of itself in exchange for cash.
Here’s how it works: Suppose a corporation makes it through the start-up phase and becomes successful. The owners wish to expand, but they are unable to do so solely through the income they earn through their operations. As a result, they can turn to the capital markets for additional money.
One way to do this is to split the company up into shares. Then, they can sell a portion of these shares on the open market in a process known as an "initial public offering," or "IPO."
A person who buys a stock is buying an actual share of the company, which makes them a partial owner. That is why stock is also referred to as "equity." This applies to both established companies and IPOs that are new to the market.
Bonds Represent Debt
Bonds, on the other hand, are debt. When an entity issues a bond, it is issuing debt with the promise to pay interest for the use of the money.
A government, corporation, or other entity that needs to raise cash will borrow money in the public market. Then, it will pay interest on that loan to investors who have loaned them the money.
Each bond has a certain par value (say, $1,000) and pays a coupon to investors. For instance, a $1,000 bond with a 4% coupon would pay $20 to the investor twice per year ($40 annually) until it matures.
After it matures, the investor is returned the full amount of their original principal. If, for some reason, the issuer is not able to make the payment, the bond will default. This rarely happens.
The Difference for Investors
Each share of stock represents an ownership stake in a corporation. That means that the owner shares in the profits and losses of the company, although they are not responsible for its liabilities. Someone who invests in the stock can benefit if the company performs very well, and its value increases over time.
At the same time, they run the risk that the company could perform poorly and that the stock price could fall. In the worst-case scenario, the company may file for bankruptcy and even disappear altogether.
Individual stocks and the overall stock market tend to be on the riskier end of the investment spectrum in terms of their volatility and the possibility of the investor losing money in the short term. However, they also tend to provide superior long-term returns. Stocks are favored by those with a long-term investment horizon and a tolerance for short-term risk.
Bonds lack the powerful long-term return potential of stocks, but they are preferred by investors who want to increase their income. They also are less risky than stocks. While their prices fluctuate in the market—sometimes quite substantially in the case of higher-risk market segments—the vast majority of bonds tend to pay back the full amount of principal at maturity, and there is much less risk of loss than there is with stocks.
Which Is Right for You?
Many people invest in both stocks and bonds to diversify. Deciding on the appropriate mix of stocks and bonds in your portfolio is a function of your time horizon, tolerance for risk, and investment objectives. Typically, stocks and bonds do not fluctuate at the same time.
If seeing a stock price fall quickly would cause you to panic, and/or if you are close to retiring and may need the money soon, then a mix with more bonds could be the better option for you.
If you're a young investor who has a lot of time, you can benefit in a weak market. You can buy stocks after their prices drop, and sell them when their prices increase again.
Each person has their own financial goals. Try to keep them in mind when choosing which investments to make.