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A Beginner’s Guide to Stocks and Bonds

April 22, 2022
8
min

Stocks and bonds offer two distinct choices for investors: investing in the stock market produces bigger gains, and bonds are considered safer, but they return less.

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When it comes to where to put their money, investors often ask a key question: stocks versus bonds? Both are types of securities that corporations and other entities use to raise money. But in many respects the two are opposites, with very different purposes. Once an investor understands the main characteristics of each, they might opt for a portfolio that contains a mix of both rather than one to the exclusion of the other.

What are stocks and bonds?

A stock provides an ownership stake, known as equity, in a company. People who buy a share of stock are purchasing a slice of a company. The stock trades on an exchange. The price of a share increases or declines based on investors’ assessments of the company’s outlook, profitability, and other factors. Investors can make money when a share they’ve purchased rises in price, and lose it when they fall. They may also make money when the company pays out dividends. Stockholders may enjoy voting rights that can influence the company’s direction.  

A bond, in comparison, is a fixed-income, or debt, security. When investors buy a bond from a company, government, or other entity, they essentially loan that entity money. The entity, in exchange, pays out regular interest payments to the investor. The interest payments happen for a set period of time until the bond reaches maturity. At that point, the bond would have paid out the investor’s original investment, called principal, as well as interest. 

Stocks vs. bonds: key differences

Stocks and bonds differ in many important ways.

Risk

Stocks are considered riskier than bonds. Their value can rise or fall sharply based on factors ranging from company earnings to global economic conditions. Bonds provide a regular payment that, once locked in, isn’t affected by financial markets or unexpected events. Bond prices, though, do fluctuate when interest rates change. Furthermore, if a borrower defaults and declares bankruptcy, a bond investor can lose some, but generally not all, of their principal. In the same situation, a stock owner might lose everything.

Return

Stocks offer the potential for significant gains but also significant losses. While stocks have outperformed bonds over the long-term, they’ve also suffered bigger annual declines in some years. The Standard & Poor’s 500 Index of large stocks tumbled 36.6% in 2008 amid the financial crisis. That year the annual return on U.S. Treasury bonds was 20.1%. Large stocks have returned an annual average of about 10% since 1926; long-term Treasury bonds have returned between 5% and 6%.

Ratings

Ratings services grade a bond’s level of risk by evaluating the credit quality of the company or other issuer. The rating reflects the issuer’s financial strength and ability to repay its debt. Ratings categorize bonds into investment grade and non-investment grade, also called high-yield or junk. Within the two broad classifications, bonds are rated on a sliding scale from virtually risk free to in default.

Stock analysts rate a company’s shares mainly on an anticipated price, usually by a certain date. Stock ratings are less specific than bond ratings. They generally consist of five designations: buy, sell, hold, underperform, and outperform, although some analysts use other terms.

Rights

Stockholders own a piece of a company and face the risks and rewards of ownership. They may enjoy voting rights that can influence the company’s management and policies. Corporate executives and directors have a fiduciary duty to make decisions that boost shareholder value. Companies might declare special dividends or buy competitors to satisfy stockholders. 

Management doesn’t have the same obligation to bondholders, whose returns are locked in and don’t depend on a stock price. Bondholders don’t have voting rights and can’t affect a company’s actions. However, bondholders do enjoy more clout if a company declares bankruptcy. If a company’s assets are divvied up in a liquidation, paying back bondholders takes precedence over paying stockholders. 

Investing

Stocks trade on exchanges that act as central marketplaces to bring buyers and sellers together. The New York Stock Exchange and the Nasdaq are the two biggest U.S. exchanges. Investors can buy, sell, and trade individual shares on these stock exchanges through an online or other brokerage. 

The bond market doesn’t have a centralized trading platform; bonds are mainly sold over the counter and are bought and sold between counterparties, although a brokerage may give investors direct access to corporate bonds, Treasuries, and municipal bonds from their inventory of those securities. Individual investors do not typically participate in the bond market. 

Individuals, however, can buy bundles of bonds as well as stocks, combined in the same security when they purchase a mutual fund or exchange-traded fund (ETF). Mutual funds are available through brokerages and directly from the financial institution that manages the fund. ETFs trade on exchanges like stocks and can be purchased through brokerage accounts. 

Potential benefits and risks of bonds

Bonds offer both benefits and drawbacks for investors compared to stocks. 

Potential benefits of bonds

  • Steady returns. Bonds deliver regular interest payments and return an investor’s principal.
  • Less risk. Bonds’ returns aren’t affected by volatility in financial markets or world events. The U.S. government backs Treasury bonds, which are virtually risk free.
  • Fixed income. Bonds’ fixed-income payments are typically higher than returns from bank savings accounts or certificates of deposit.
  • Guaranteed payments. A bond guarantees to make predetermined payments over a specified time.
  • Precedence over stockholders. Bondholders come before stockholders in the distribution of assets should a company go bankrupt and liquidate. 

Risks of bonds

  • Lower returns. Bonds generally provide a lower return than stocks do.
  • Larger minimum investment. Bonds are typically sold in denominations of $1,000, although some government bonds can be bought for much less. 
  • Interest rate risk. When interest rates rise, a bond’s price falls.
  • Inflation. Inflation hurts an investor who relies on a bond’s fixed-interest payments by eroding their purchasing power.
  • Illiquidity. Bonds often are less liquid than stocks and may not be easy to sell at a desired price.
  • Call risk. In some cases, an issuer can “call,” or retire, a bond before its maturity date, depriving the investor of the expected returns.
  • Default. Corporate bonds can default if the issuer can’t repay the debt; countries can default on sovereign debt if they’re unable or unwilling to pay.

Potential benefits and risks of stocks

Stocks offer both benefits and risks that differ in many ways from bonds.

Potential benefits of stocks

  • Higher returns. Stocks have outperformed bonds over the long term, rewarding investors with 10% average annual returns.
  • Dividends. Companies may pay dividends that can cushion a drop in the share price or provide investors with extra income.
  • Liquidity. Most shares trade on transparent public exchanges where investors can easily buy and sell at any time for the current price.
  • Trading cost. Competition among brokerages has reduced the cost to buy and sell shares to zero in many cases.
  • Small minimum investment. Investors can buy a single share of stock or a fractional share for a small amount of a pricey stock.
  • Potential growth. Stocks generally appreciate with a strong economy and can hedge against inflation. 

Potential risks of stocks

  • Volatility. Stock prices can change sharply, hurting investors when prices fall.
  • No guarantees. Stocks do not offer a regular return or a guarantee against losing money.
  • Last to collect. Common stockholders are the last to collect if a company goes bankrupt; if there’s nothing left in a liquidation, they can lose everything.
  • Rating risk. Stocks can fall sharply if an analyst downgrades their rating on the company.
  • Time commitment. Investors must pay close attention to the stock market to track the performance of their shares.

FAQs about stocks and bonds

What percentage of an investor’s portfolio should be in stocks versus bonds?

It’s rare that an investor will choose a portfolio of all stocks or all bonds. But how do they determine a blend that’s right for them?

Most investors consider their age and risk tolerance when deciding the makeup of their portfolio. One rule of thumb suggests allocating stock by subtracting the investor’s age from 100. A 30-year-old would have 70% of their portfolio in stocks and a 70-year-old would have 30%. Investors who start early can make up for any losses in stocks. As retirement approaches, investors generally shift toward bonds that carry less risk.  

What happens to stocks and bonds when a company goes bankrupt?

Bondholders are more likely to recover at least part of their initial investment if a company declares bankruptcy. Secured bondholders whose money is guaranteed by collateral or a contract are paid first. Investors with unsecured bonds are paid next. Stockholders are paid only after all other claims on the company have been resolved—if there’s money left over.

How do you buy stocks and bonds?

Investors buy stocks on public exchanges through an online brokerage account or human broker. They buy bonds over the counter through a broker network, or sometimes from the underwriting investment bank, rather than on a centralized exchange. U.S. government bonds are sold online on the TreasuryDirect website.

Are bonds safe if the stock market crashes?

Bonds are generally safer than stocks, regardless of stock market performance. U.S. Treasuries and other government bonds do best in a market crash as investors look for risk-free, guaranteed returns. Bonds usually outperform stocks in an equity bear market. When stocks plunge, central banks often lower interest rates to stimulate the economy. When interest rates fall, bond prices rise as investors seek higher returns via the fixed yields on existing bonds.

The bottom line 

Stocks and bonds offer two distinct choices for investors. Each security has unique attributes, risks, and rewards. In general, investing in the stock market produces bigger gains but involves the potential for bigger losses. Bonds are considered safer, but they generally return less than stocks. Most investors choose a mix of stocks and bonds, and that mix becomes more conservative as they approach retirement age.

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