As such, when you start investing for your future, it may be difficult to decide how you should invest your money. After all, if you don’t know the key differences between stocks and bonds, how will you decide which is best to buy?
For most investors, the best decision is to invest in a mix of stocks and bonds. This leads to a properly diversified portfolio, helping to protect you from risk while offering up exposure to opportunities that have the potential to generate a strong return.
What Are Stocks?
As defined by the U.S. Securities Exchange Commission, “stocks are a type of security that gives stockholders a share of ownership in a company.”
Stocks are commonly referred to as equities because when you purchase a stock, you’re essentially purchasing equity in a company. The total value of a company is known as its market capitalization or market cap, and it’s equal to the total combined value of all outstanding shares of stock in that company.
For example, as of July 2020, there are 4.33 billion shares of Apple stock currently outstanding. So if you purchase one share of Apple stock, you own 1/4.33 billionth of the company. If Apple’s stock trades at $350 per share, that means its market cap is about $1.5 trillion (4.33 billion shares x $350).
Because stockholders own equity in the companies in which they invest, shares of stock generally come with voting rights that give investors a say in how a publicly traded company is run. Investors often have a say in large financial transactions, acquisitions, allocation of funding, cosmetic transactions like stock splits, and more.
Of course, the value of shares in any stock fluctuate depending on the value of the underlying company they represent. As stock prices move up and down, investors either earn money or lose it. Money can also be earned through the issuance of dividends — the act of a publicly traded company distributing a portion of its profits directly to its investors.
Pro tip: If you’re new to investing, there are several brokers that are good for beginners. Some even allow you to invest with as little as $5.
What Are Bonds?
Bonds work quite a bit differently than stocks. The biggest difference is that bonds don’t give holders an ownership interest in a company. Instead, they act as loans.
Bonds are fixed-income instruments representing loans made by investors to borrowers. The most common borrowers are corporations or government municipalities, making the most common bonds corporate bonds and municipal bonds.
Those who own bonds are creditors of the bond issuer. Like other types of fixed loans, bonds come with terms including the date at which 100% of the money loaned is due to be paid back in full, plus variable-interest or fixed-interest payments known as coupon payments, which are made by the borrower to the bondholder.
As with consumer loans, interest or coupon rates vary depending on multiple factors. The most decisive determining factors of bond coupon rates include the time to maturity and credit worthiness of the borrower. The longer the bondholder must hold the bond until it reaches maturity, the higher the coupon rate normally is. Also, companies and municipalities with lower levels of creditworthiness must pay higher coupon rates than those with better credit.
Once bonds are issued, they can be bought and sold. If a bondholder decides they no longer want to hold the bond, they can sell it to someone else on the open market. Moreover, companies and municipalities can choose to buy their own bonds back. This often happens when projects are completed early, if the issuer enjoys a large injection of funds, or if the issuer earns a better credit rating that gives them the opportunity to issue new bonds with lower coupon rates.
Stocks vs. Bonds: Pros and Cons
As with any investment vehicle, stocks and bonds come with their own lists of pros and cons.
Stocks are the darling of the investing community, generally looked upon favorably and the first thing considered when it comes to making your money grow for you. However, as with anything else, investing in stocks comes with its fair share of pros and cons.
Pros of Owning Stocks
There are several reasons stocks have earned a positive opinion among investors.
- Ownership. There’s quite a bit of comfort in knowing that when you purchase a share of stock, you’re not just purchasing a piece of paper with a perceived value. Every share you own represents legal ownership of the company you’re investing in. This legal ownership gives you the right to speak out with regard to how the company is being run and what you believe management can do to make beneficial changes. Most single shareholders don’t represent enough of the company to make much of a difference. However, when shareholders band together, their combined ownership can be enough to force changes to a struggling company and to improve the company’s value for everyone involved.
- Exposure to Large Potential Gains. Fixed investments like bonds don’t provide the opportunity for above-average gains. When purchasing bonds, you know what the rate of return is going to be. According to CNN Money, long-term government bonds have returned 5% to 6% annually since 1926, but in today’s market the interest rates are much, much lower. With the average annualized return of the S&P 500 during the past 90 years coming in at around 9.8%, stocks are known for producing higher returns. However, savvy investors can take that a step further. Making properly timed trades in the stock market can yield gains many times this size in the matter of a single day.
- Avoiding Inflation-Related Losses. Most savings accounts offer small interest rates that are not necessarily intended to keep up with inflation. As a result, long-term savings accounts tend to lose value as inflation reduces the purchasing power of money. Although there’s no guarantee a single stock will outpace inflation, a well-diversified portfolio of stocks and other financial instruments that are known to be stable growth investments should do so handily. Investing in stocks as a large part of a properly proportioned portfolio typically protects your savings from inflation-related losses.
- Potential Dividends. Not all stocks pay dividends, but plenty do. In fact, there is an entire strategy revolving around investing in stocks that pay dividends. This gives investors a way to share in the profits publicly traded companies experience.
- Liquidity. Stocks are highly liquid investment vehicles. That means they’re easy to buy and sell. As a result, if you invest in a stock and later decide it’s time to sell, you won’t be stuck holding the bag for any long period of time as you await a buyer.
- Helping the Economy. The U.S. economy and the stock market are closely tied to each other. In order to raise funds to fulfill projects, offer jobs, and grow their companies, corporations depend on investor dollars. The more investor dollars that are available, the more investors are assisting in broader economic development. So, investing in stocks isn’t just about generating gains; the economic implications offer a feel-good aspect too.
Cons of Owning Stocks
While stocks are what most people think of when they think of investing, they do come with some drawbacks.
- Exposure to Extreme Losses. While investments in stable stocks that represent well-known companies tend to grow over time, there is always the potential for extreme losses. For example, thousands of investors lost millions of dollars investing in what everyone believed to be one of the world’s largest and most successful companies, Enron. When the company collapsed due to one of the biggest financial scandals in stock market history, many shareholders lost everything.
- Getting Paid Last. If something goes wrong and a company you’ve invested in falls into bankruptcy or goes out of business, stockholders will be the last to be paid. Before beleaguered companies return any money to shareholders, they must first pay all of their employees, service providers, and creditors — essentially everyone else involved with them.
- At the Mercy of the Investing Community. Stocks rise in price when investors are more willing to buy them than sell them. On the other hand, they fall when investors are more willing to sell than to buy. Ultimately, share prices are the result of investor perceptions and sometimes raw emotions. As such, when you invest in a share of stock, your investing dollars are at the mercy of the whims of the investing community.
Bonds are a safer play than stocks but generally lead to better yields than savings accounts, making them a strong bet for the risk averse investor. Nonetheless, they come with their own unique pros and cons.
Pros of Owning Bonds
Bonds are a great investment vehicle. Some of the benefits you’ll enjoy when investing in bonds include:
- Protection From Losses. Bonds are safer investments than stocks. That’s because stock values are at the mercy of investor opinion. If the overwhelming opinion among investors is that a stock is going to fall, that opinion becomes a self-fulfilling prophecy as investors sell shares. Bonds are not nearly as volatile. Because bonds are debts, they’re subject to strict and predictable terms, further protecting investors from losses.
- Known Returns. Because bonds have predetermined coupon rates and expiration dates, investors who purchase bonds have the benefit of knowing what the potential returns of the bond will be in advance, rather than subjecting themselves to the uncertainty of the stock market. The interest rate on a bond is defined from the start, and when a bond matures, you know you will receive back 100% of your initial investment.
- Getting Paid Before Shareholders. Some of the largest companies face bankruptcy from time to time. Some are even pushed out of business. In these cases, stockholders of these companies experience extreme losses, oftentimes losing their entire principal investment. Although there’s always a chance of losing money in any investment, that chance is much lower with bonds, as even companies headed for bankruptcy or closure pay bond investors back before shareholders.
- Preserving Capital While Earning Returns. Bonds pay coupon rates that provide predictable passive income streams. The rate you earn on a bond is generally better than what you receive from the interest on a savings account. At the same time, if you hold bonds to maturity, you’re paid your entire principal investment back, giving you a way to preserve your capital while outpacing inflation-related losses.
Cons of Owning Bonds
Stocks are not alone. Investors in bonds have their own share of cons to consider before diving in.
- Smaller Returns. The primary goal of investors is to make their money work for them. Ultimately, you want to ensure your investment dollars are making as much money as possible in the safest way possible. While bonds are great on the safety side of the equation, they’re lackluster on the returns side. With returns on bonds ranging from 5% to 6% historically — and typically lower in today’s low-interest-rate environment — a properly diversified and well-researched portfolio of stock investments has the potential to nearly double your returns.
- Liquidity Risks. One of the benefits of investing in stocks is that they’re extremely easy to sell when you decide it’s time to get out of an investment. Bonds aren’t nearly as liquid. Should you need to access your funds, or if you decide a company may be going under and it’s time to get your money back, you may have a hard time selling bonds to another investor. If you can’t find a buyer, you’ll be forced to wait until the bond’s maturity date to get your money back.
- Larger Required Investments. In most cases, bonds are sold in $1,000 denominations. That means if you want to invest in most bond opportunities, you have to be willing to pony up at least $1,000 to do so. On the other hand, stock prices can range from pennies to thousands of dollars, making them more accessible for beginner investors with less capital.
Determining the Best Allocation Strategy
When it comes to the question of whether you should invest in stocks or bonds, the answer for most is: You should invest in both. A properly diversified portfolio includes exposure to stocks for large potential gains and exposure to bonds for more stable growth and protection against any extreme losses.
One of the best ways to decide how much of your portfolio should be invested in stocks and how much money should be invested in bonds is to use your age. In particular, your age should be the percentage of your portfolio you invest in bonds.
For example, if you’re 21 years old, 21% of your investing dollars should be invested in bonds and 79% should be invested in stocks. If you’re 53 years old, 53% of your portfolio should be invested in bonds and only 47% should be invested in stocks.
There are several variations on this formula, but the idea is the same: When you’re young, focus more on stocks. The older you get, the more you should lean into bonds.
The reasoning behind this strategy has to do with the amount of time your money has to grow for you. If you’re young, your investment gains have more time to compound and you have plenty of time to make money back should investments go south. So, you should invest in a higher-risk and higher-potential-reward strategy.
As you age and get closer to retirement, it becomes more and more important that your investments deliver stable returns with lower volatility and risk. In this case, investing more money in bonds provides a safe haven for the majority of your portfolio while letting a smaller portion in stocks continue to provide some potential for large gains.
Stocks and bonds are both important pieces of the puzzle that is a properly diversified investment portfolio. Although stocks come with added risk, they also open the door to larger potential gains. On the other hand, bonds help reduce the potential for massive losses in your portfolio.
When you get started in investing, remember the age-related allocation strategy. Following this approach will ensure you have the proper exposure to potential gains in the stock market and the proper protection from risks that your bond investments provide, based on the amount of time your money has to grow for you before you need it.
Are you invested in stocks, bonds, or both? How do you decide what percentage of your portfolio to invest in stocks versus bonds?