What’s the difference between stocks and bonds?
Stocks give you partial ownership in a corporation, while bonds are a loan from you to a company or government. The biggest difference between them is how they generate profit: stocks must appreciate in value and be sold later on the stock market, while most bonds pay fixed interest over time.
Here’s a deeper look at how these investments work:
Stocks represent partial ownership, or equity, in a company. When you buy stock, you’re actually purchasing a tiny slice of the company — one or more “shares.” And the more shares you buy, the more of the company you own. Let’s say a company has a stock price of $50 per share, and you invest $2,500 (that’s 50 shares for $50 each).
Now imagine, over several years, the company consistently performs well. Because you’re a partial owner, the company’s success is also your success, and the value of your shares will grow just like the value of the company. If its stock price rises to $75 (a 50% increase), the value of your investment would rise 50% to $3,750. You could then sell those shares to another investor for a $1,250 profit.
Of course, the opposite is also true. If that company performs poorly, the value of your shares could fall below what you bought them for. In this instance, if you sold them, you’d lose money.
Stocks are also known as corporate stock, common stock, corporate shares, equity shares and equity securities. Companies may issue shares to the public for several reasons, but the most common is to raise cash that can be used to fuel future growth.
Bonds are a loan from you to a company or government. There’s no equity involved, nor any shares to buy. Put simply, a company or government is in debt to you when you buy a bond, and it will pay you interest on the loan for a set period, after which it will pay back the full amount you bought the bond for. But bonds aren’t completely risk-free. If the company goes bankrupt during the bond period, you’ll stop receiving interest payments and may not get back your full principal.
Let’s say you buy a bond for $2,500 and it pays 2% annual interest for 10 years. That means every year, you’d receive $50 in interest payments, typically distributed evenly throughout the year. After a duration of 10 years, you would have earned $500 in interest, and you’d get back your initial investment of $2,500, too. Keeping a bond for the full duration is known as “holding until maturity.”
With bonds, you usually know exactly what you’re signing up for, and the regular interest payments can be used as a source of predictable fixed income over long periods.
The durations of bonds depend on the type you buy, but commonly range from a few days to 30 years. Likewise, the interest rate — known as yield — will vary depending on the type and duration of the bond.
Comparing stocks and bonds
While both instruments seek to grow your money, the way they do it and the returns they offer are very different.
Equity vs. debt
When you hear about equity and debt markets, that’s typically referring to stocks and bonds, respectively.
Equity is the most popular liquid financial asset (an investment that can be easily converted into cash) in the U.S. In 2018, $221.2 billion worth of equity was issued in the country. Corporations often issue equity to raise cash to expand operations, and in return, investors are given the opportunity to benefit from the future growth and success of the company.
Buying bonds means issuing a debt that must be repaid with interest. You won’t have any ownership stake in the company, but you’ll enter into an agreement that the company or government must pay fixed interest over time, as well as the principal amount at the end of that period.
Capital gains vs. fixed income
Stocks and bonds generate cash in different ways, too.
To make money from stocks, you’ll need to sell the company’s shares at a higher price than you paid for them to generate a profit or capital gain. Capital gains can be used as income or reinvested, but they will be taxed as long-term or short-term capital gains accordingly.
Bonds generate cash through regular interest payments. The distribution frequency can vary, but it’s generally as follows:
Treasury bonds and notes: Every six months until maturity.
Treasury bills: Only upon maturity.
Corporate bonds: Semiannually, quarterly, monthly or at maturity.
Bonds can also be sold on the market for a capital gain, though for many conservative investors, the predictable fixed income is what’s most attractive about these instruments. Similarly, some types of stocks offer fixed income that more resembles debt than equity, but again, this usually isn’t the source of stocks’ value.
Another important difference between stocks and bonds is that they tend to have an inverse relationship in terms of price — when stock prices rise, bonds prices fall, and vice versa.
Historically, when stock prices are rising and more people are buying to capitalize on that growth, bond prices have typically fallen on lower demand. Conversely, when stock prices are falling and investors want to turn to traditionally lower-risk, lower-return investments like bonds, their demand increases, and in turn, their prices.
The table below compares the total annual returns of the S&P 500 (stocks) and the annual returns of the Bloomberg Barclays U.S. Aggregate Index (bonds) since 2000. And while there are outliers, especially more recently, the inverse relationship seems to hold true: Bonds tend to have their best years when stocks are at their worst, and the other way around.
Bloomberg Barclays U.S. Agg Index (%)
Bond performance is also closely tied to interest rates. For example, if you buy a bond with a 2% yield, it could become more valuable if interest rates drop, because newly issued bonds would have a lower yield than yours. On the other hand, higher interest rates could mean newly issued bonds have a higher yield than yours, lowering demand for your bond, and in turn, its value.
To stimulate spending, the Federal Reserve typically cuts interest rates during economic downturns — periods that are usually worse for many stocks. But the lower interest rates will send the value of existing bonds higher, reinforcing the inverse price dynamic.
The risks and rewards of each
The biggest risk of stock investments is the share value decreasing after you’ve purchased them. There are several reasons stock prices fluctuate (you can learn more about them in our stock starter guide), but in short, if a company’s performance doesn’t live up to investor expectations, its stock price could fall. Given the numerous reasons a company’s business can decline, stocks are typically riskier than bonds.
However, with that higher risk can come higher returns. As of June 11, 2020, the S&P 500 has a 10-year average annual return of 10.65%, while the U.S. bond market, measured by the Bloomberg Barclays U.S. Aggregate Bond Index, has a 10-year total return of 3.92%.
U.S. Treasury bonds are generally more stable than stocks in the short term, but this lower risk typically translates to lower returns, as noted above. Treasury securities, such as government bonds and bills, are virtually risk-free, as these instruments are backed by the U.S. government.
Corporate bonds, on the other hand, have widely varying levels of risk and returns. If a company has a higher likelihood of going bankrupt and is therefore unable to continue paying interest, its bonds will be considered much riskier than those from a company with a very low chance of going bankrupt. A company’s ability to pay back debt is reflected in its credit rating, which is assigned by credit rating agencies like Moody’s and Standard & Poor’s.
Corporate bonds can be grouped into two categories: investment-grade bonds and high-yield bonds.
Investment grade. Higher credit rating, lower risk, lower returns.
High-yield (also called junk bonds). Lower credit rating, higher risk, higher returns.
These varying levels of risks and returns help investors choose how much of each to invest in — otherwise known as building an investment portfolio. According to Brett Koeppel, a certified financial planner in Buffalo, New York, stocks and bonds have distinct roles that may produce the best results when they’re used as a complement to each other.
“As a general rule of thumb, I believe that investors seeking a higher return should do so by investing in more equities, as opposed to purchasing riskier fixed-income investments,” Koeppel says. “The primary role of fixed income in a portfolio is to diversify from stocks and preserve capital, not to achieve the highest returns possible.”
Stock/bond portfolio allocation
There are many adages to help you determine how to allocate stocks and bonds in your portfolio. One says that the percentage of stocks in your portfolio should be equal to 100 minus your age. So, if you’re 30, your portfolio should contain 70% stocks, 30% bonds (or other safe investments). If you’re 60, it should be 40% stocks, 60% bonds.
The core idea here makes sense: As you approach retirement age, you can protect your nest egg from wild market swings by allocating more of your funds to bonds and less to stocks.
However, detractors of this theory may argue this is too conservative of an approach given our longer lifespans today and the prevalence of low-cost index funds, which offer a cheap, easy form of diversification and typically less risk than individual stocks. Some argue that 110 or even 120 minus your age is a better approach in today’s world.
For most investors, stock/bond allocation comes down to risk tolerance. How much volatility are you comfortable with in the short term in exchange for stronger long-term gains? One study from Vanguard collected data from 1926 to 2019 to see how various allocations would have performed over that period, shown below. Using this data, consider how it fits in with your own timeline and risk tolerance to determine what may be a good allocation for you.
Keep in mind that with annual averages, rarely does any particular year actually resemble its average. For example, the S&P 500 finished 2008 down 37%, but by the end of 2009, regained 26.46%, partially offsetting 2008’s losses. Conversely, the Bloomberg Barclays U.S. Aggregate Bond Index finished 2008 up 5.24%, and in 2009, finished 5.93% higher.
Consider this when looking at the column on the right: A portfolio comprising 100% stocks was almost twice as likely to end the year with a loss than a portfolio of 100% bonds. Are you willing to weather those downturns in exchange for a higher likely return over the long term, considering your timeline?
The upside down: When debt and equity roles reverse
There are certain types of stocks that offer the fixed-income benefits of bonds, and there are bonds that resemble the higher-risk, higher-return nature of stocks.
Dividends and preferred stock
Dividend stocks are often issued by large, stable companies that regularly generate high profits. Instead of investing these profits in growth, they often distribute them among shareholders — this distribution is a dividend. Because these companies typically aren’t targeting aggressive growth, their stock price may not rise as high or as quickly as smaller companies, but the consistent dividend payouts can be valuable to investors looking to diversify their fixed-income assets.
Preferred stock resembles bonds even more, and is considered a fixed-income investment that’s generally riskier than bonds, but less risky than common stock. Preferred stocks pay out dividends that are often higher than both the dividends from common stock and the interest payments from bonds.
Bonds can also be sold on the market for capital gains if their value increases higher than what you paid for them. This could happen due to changes in interest rates, an improved rating from the credit agencies or a combination of these.
However, seeking high returns from risky bonds often defeats the purpose of investing in bonds in the first place — to diversify away from equities, preserve capital and provide a cushion for swift market drops.
Disclosure: The author held no positions in the aforementioned securities at the original time of publication.
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